Global
Dear Client, In this report, we image a hypothetical timeline of key economic and financial events spanning the next five years. The events described in the report correspond with our view that the global economy will continue to expand into the second half of 2019, before succumbing to a recession and a decade of stagflation in the 2020s. This warrants an overweight position in risk assets for the next 6-to-12 months, but a much more cautious stance thereafter. Charts 1-4 provide a visual representation of how we see the main asset classes evolving over the coming years. Best regards, Peter Berezin, Chief Global Strategist Feature I. The Blow-Off Phase December 4, 2017: U.S. stocks fall by 1.7% on reports that Mitch McConnell does not have enough votes to get the tax bill through the Senate. A sell-off in high-yield markets and a tightening of financial conditions in China aggravate the situation. December 13, 2017: The Fed hikes rates by 25 basis points, taking the Fed funds target range to 1.25%-to-1.5%. December 14, 2017: Global equities continue to weaken. The S&P 500 suffers its first 5% correction since June 2016. December 15, 2017: The correction ends on news that the Senate will consider a revised bill which trims the size of corporate tax cuts and uses the savings to finance a temporary reduction in payroll taxes. President Trump and House leaders promise to go along with the proposal. The PBoC also injects fresh liquidity into the Chinese financial system. December 29, 2017: Global equities rally into year-end. The S&P 500 hits 2571 on December 29, placing it just shy of its November high. The dollar also strengthens, with EUR/USD closing at 1.162. The 10-year Treasury yield finishes the year at 2.42%. January 10, 2018: The global cyclical bull market in stocks continues. European and Japanese indices power higher. Both the NASDAQ and the S&P 500 hit fresh record highs. EM stocks move up but lag their DM peers, weighed down by a stronger dollar. January 12, 2018: U.S. retail sales surprise on the upside. Department store stocks, having been written off for dead just a few months earlier, end up rising by an average of 40% between November 2017 and the end of January. February 14, 2018: The euro area economy continues to grow at an above-trend pace. Nevertheless, inflation stays muted due to high levels of spare capacity across most of the region and the lagged effects of a stronger euro. The 2-year OIS spread between the U.S. and the euro area widens to a multi-year high. February 26, 2018: China's construction sector cools a notch, but industrial activity remains robust, spurred on by a cheap currency, strong global growth, and rising producer prices. Chinese H-shares rise 13% year-to-date, beating out most other EM equity indices. March 14, 2018: The U.S., Canada, and Mexico reach a last-minute deal to preserve NAFTA. The Canadian dollar and Mexican peso breathe a sigh of relief. March 16, 2018: In a surprise decision, Donald Trump nominates Kevin Hassett as Fed vice-chair. Trump cites the "tremendous job" Hassett did in selling the GOP's tax cuts. A number of Fed appointments follow. Most of the picks turn out to be more hawkish than investors had expected. This gives the greenback further support. March 18, 2018: Pro-EU parties do better than anticipated in the Italian elections. Italian bond spreads compress versus the rest of Europe. March 21, 2018: The Fed raises rates again, bringing the fed funds target range up to 1.50%-to-1.75%. April 8, 2018: Bank of Japan governor Kuroda is granted another term in office. He pledges to remain single-mindedly focused on eradicating deflation. April 11, 2018: Chinese core CPI inflation reaches 2.9%. Producer price inflation stays elevated at 6%. A major market theme in 2018 turns out to be how China went from being a source of global deflationary pressures to a source of inflationary ones. April 30, 2018: U.S. core PCE inflation jumps 0.3% in March, reaching 1.7% on a year-over-year basis. Goods and service inflation both pick up, while the base effects from lower cell phone data charges in the prior year drop out of the calculations. May 17, 2018: Oil prices continue to rise on the back of ongoing discipline from OPEC and Russia, smaller-than-expected shale output growth, and production disruptions in Libya, Iraq, Nigeria, and Venezuela. June 13, 2018: Strong U.S. growth in the first half of the year, a larger-than-projected decline in the unemployment rate, and higher inflation keep the Fed in tightening mode. The FOMC hikes rates again. June 25, 2018: Global capital spending accelerates further. Global industrial stocks go on to have a banner year. June 27, 2018: Wage growth in the U.S. accelerates to a cycle high. Donald Trump takes credit, stating that "this wouldn't have happened" without him or his tax cuts. July 31, 2018: The Japanese labor market tightens further. The unemployment rate falls to 2.6%, 1.2 percentage points below 2007 levels, while the ratio of job vacancies-to-applicants moves further above its early-1990s bubble high. A number of high-profile companies announce plans to raise wages. August 2, 2018: A brief summer sell-off sees global equities dip temporarily, but strong global earnings growth keeps the cyclical bull market in stocks intact. August 28, 2018: The London housing market continues to weaken, with home prices falling by 9% from their peak. The rest of the U.K. economy remains fairly resilient, however. EUR/GBP closes at 0.87. August 31, 2018: The Greek bailout program ends and a new one begins. Greece's economy continues to recover, but Tsipras fails to obtain debt relief from creditors. September 7, 2018: The U.S. unemployment rate falls to a 49-year low of 3.7%, nearly a full percentage below the Fed's estimate of NAIRU. September 26, 2018: The Fed raises rates again. By now, the market has gone from pricing in only two hikes for 2018 at the start of the year to pricing in almost four. September 27, 2018: Profit growth in the U.S. moderates somewhat as higher wage costs take a bite out of earnings. Nevertheless, stock market sentiment remains buoyant. Retail participation, which had been dormant for years, takes off. CNBC sees a surge in viewers. Micro cap stocks go wild. October 7, 2018: The outcome of Brazil's elections shows little appetite for major structural reforms. Economic populism lives on. October 31, 2018: Realized inflation and inflation expectations continue grinding higher in Japan, triggering market speculation that the BoJ will abandon its yield-curve targeting policy. The resulting rally in the yen is short-lived, however. At its monetary policy meeting, the Bank of Japan indicates that it has no near-term plans to modify its existing strategy. November 6, 2018: The Democrats narrowly regain control of the House but fail to recapture the Senate. Investors shrug off the results, figuring correctly that a Republican Senate will keep Trump's corporate tax cuts in place and that Democrats will agree to extend the expiring payroll tax cut and other tax measures that benefit the middle class. December 7, 2018: The U.S. unemployment rate falls to 3.5%. Donald Trump tweets "You're welcome, America". December 19, 2018: The Fed raises rates for the fourth time that year - one more hike than it had signaled in its December 2017 "dot plot" - taking the fed funds target range to 2.25%-2.5%. December 31, 2018: The MSCI All-Country Index finishes up 12% for the year (in local-currency terms), led by the euro area and Japan. U.S. stocks gain 8%. EM equities manage to rise 6%. Small caps edge out large caps, value stocks beat growth stocks, and cyclical stocks outperform defensives. December 31, 2018: The 10-year U.S. Treasury yield finishes the year at 3.05%. German bund yields reach 0.82%, U.K. gilt yields rise to 1.7%, Canadian yields hit 2.3%, and Australian yields back up to 3%. Japanese 10-year yields remain broadly flat, but the 20-year yield moves up 40 basis points to nearly 1%. Credit spreads finish the year close to where they started, providing a modest carry pick-up over high-quality government bonds. December 31, 2018: The DXY index rises 4% to 98. EUR/USD closes at 1.11, USD/JPY at 123, GBP/USD at 1.31, and AUD/USD at 0.76. The Canadian dollar manages to edge up against the greenback on the year, with CAD/USD finishing at 0.81. The Chinese yuan also strengthens to 6.4 versus the dollar. December 31, 2018: Brent and WTI spot prices finish the year at $65 and $63, respectively. Copper and metal prices are broadly flat for the year, having faced the dueling forces of a stronger dollar (a negative) and above-trend global growth (a positive). Gold sinks to $1,226. II. The Clouds Darken February 22, 2019: The global economy starts to decelerate. The slowdown is led by China, where the government's crackdown on shadow banking activities begins to take a bigger toll on growth. Most measures of U.S. economic activity also soften somewhat in the first two months of the year. Investors take heart in the hope that the economy will achieve a soft landing, allowing the Fed to moderate the pace of rate hikes. February 27, 2019: In an otherwise mundane day, the S&P 500 edges up 0.3% to 2832. Little do investors know that this marks the cyclical peak in the U.S. stock market. March 13, 2019: Hopes that the Fed can take its foot off the brake are dashed when the Bureau of Labor Statistics reveals that inflation rose by more than expected in February. U.S. core CPI inflation increases to 2.9% while the core PCE deflator accelerates to 2.4%. Market chatter turns from whether the Fed can slow the pace of rate hikes to whether it needs to start hiking more rapidly than once-per-quarter. The S&P falls 2.1% on the day. March 20, 2019: The Fed lifts the funds rate target range to 2.5%-to-2.75% and signals a readiness to keep hiking rates. The 10-year Treasury yield rises to 3.3%. EUR/USD sinks to 1.08. The first quarter of 2019 marks a watershed of sorts. In 2018, the Fed raised rates because of stronger growth; in 2019, it kept raising them because of brewing inflation. As it turned out, risk assets were able to tolerate the former, but not the latter. March 29, 2019: The U.K. does not leave the EU two years after Britain invoked Article 50 of the Lisbon Treaty. The EU votes to prolong negotiations given growing political support within Britain for the country to remain part of the European bloc. April 5, 2019: The S&P 500 sinks further and is now 10% below its February high, returning close to where it was at the start of 2018. The increasingly sour mood on Wall Street does not appear to be hurting Main Street very much, however. The U.S. unemployment rate edges down further to 3.4%. Euro area growth remains resilient. May 31, 2019: The Brazilian government announces that the fiscal deficit will come in larger than originally expected. USD/BRL slips to 3.45. June 4, 2019: Jens Weidmann, who had gone out of his way to soften his hawkish rhetoric over the preceding months, is chosen to succeed Mario Draghi, whose term expires in October. Nevertheless, the euro still strengthens on the news. June 6, 2019: Markets temporarily regain their composure. The S&P 500 gets back to within 4% of its all-time high. The reprieve does not last long, however. June 12, 2019: The Fed hikes rates, taking the fed funds target range to 2.75%-to-3%. The FOMC cites inflation as its primary concern. July 8, 2019: Global risk assets weaken anew as a fiscal crisis grips Brazil. Turkey, South Africa, and a number of other emerging markets show increasing signs of fragility. August 20, 2019: Korean exports, a leading indicator of the global business cycle, decelerate once again. Global PMIs sag, as do most measures of business confidence. September 25, 2019: Despite a slowing U.S. economy, the Fed hikes rates again, bringing the fed funds target range to 3%-to-3.25%. The FOMC justifies the decision based on the fact that the unemployment rate is below NAIRU, core inflation is above the Fed's 2% target, and real rates are less than 1%. To assuage markets, Jay Powell suggests that the Fed could keep rates on hold in December. This turns out to be more prescient than he realizes. It will be another three years before the Fed raises rates again. By then, Powell is no longer the Fed chair. September 30, 2019: Commodity prices tumble, further adding to the pressure facing emerging markets. The U.S. yield curve inverts for the first time during this business cycle. The dollar, which previously strengthened due to a hawkish Fed, now starts strengthening on flight-to-safety flows back into the U.S. The yen appreciates even more than the greenback. October 15, 2019: The bottom falls out of the Canadian housing market. Home sales dry up and prices begin to sink. The Canadian dollar, which peaked back in February at 83 cents, falls to 74 cents against the U.S. dollar. October 19, 2019: A failed North Korean launch lands a missile 80 kilometres from Japanese shores. Prime Minister Abe pledges swift retaliation. October 21, 2019: The negative feedback loop between a rising dollar, falling commodity prices, and EM stress intensifies. Sentiment towards emerging markets deteriorates dramatically. Rumours begin to swirl that Brazil will miss a debt payment. October 23, 2019: Trump tweets "Dopey Rocketman thinks he is so smart, but we know where all his hideouts are. Sweet dreams!" October 24, 2019: News reports are abuzz about a massive buildup of troops on the North Korean side of the border. Panic grips Seoul. Asian bourses sell-off, taking global stock markets down with them. III. The Reckoning October 25, 2019: All hell breaks loose. North Korea's state broadcaster announces that Kim Jong-un has been "incapacitated". It later turns out that the tubby tyrant was killed by a group of military officers. Having not slept for days, Kim had become increasingly erratic and paranoid. Convinced that he was surrounded by spies and that Trump had deployed a secret weapon to read his mind, he ordered the execution of many people in his inner circle. Fearing for their lives, his henchmen decided to strike first. October 31, 2019: North Korea's new military rulers signal a desire for closer relations with China and a less belligerent posture towards the South. Over the coming decades, historians will debate whether Trump's tactics were a reckless gambit that luckily paid off, or the work of a master strategist playing 3D chess while everyone else was playing backgammon. Trump himself wastes no time in taking credit for ousting the Kim dynasty. November 4, 2019: The relief investors feel from the ebbing of tensions in the Korean Peninsula does not last long. The turmoil in emerging markets intensifies. A series of high-profile defaults rock the Chinese corporate debt market. Copper and iron ore prices nosedive. Brent swoons to $39/bbl. November 5, 2019: The head of Brazil's central bank resigns after the government pressures it to increase its holdings of government bonds in an effort to ward off an imminent default. The Brazilian real falls to nearly 6 against the dollar. Other EM currencies plunge. The Turkish lira is particularly badly hurt. December 6, 2019: The pain on Wall Street finally spreads to Main Street. U.S. payrolls rise by only 19,000 in November. Subsequent revisions ultimately show a drop of 45,000 for that month. The NBER will eventually go on to declare November as the start of the recession. December 11, 2019: Having raised rates just three months earlier, the FOMC cuts rates by 25 basis points and signals that it is willing to keep easing if economic conditions deteriorate further. December 16, 2019: Markets initially cheer the prospect of lower rates, but the euphoria is quickly forgotten. Credit spreads soar as investors price in an increasingly bleak economic outlook. Commercial real estate prices fall. Banks further tighten lending standards. IV. A Global Recession December 19, 2019: The recession spreads around the world. The ECB ditches plans to raise rates. The U.K., Sweden, Norway, Canada, Australia, and New Zealand all cut rates. In the emerging world, Korea, Taiwan, and Poland reduce interest rates, but a number of other countries - most notably, Turkey, South Africa, and Malaysia raise rates in a desperate bid to prop up their currencies so as to keep the local-currency value of their foreign-currency obligations from spiraling out of control. December 31, 2019: The S&P 500 closes at 2194, down 21% for the year. Most other bourses fare even worse. The U.S. dollar, which peaked against the euro at $1.02 just six weeks earlier, finishes at $1.07. The 10-year Treasury yield closes at 2.37%, down 68 basis points on the year. The 10-year German bund yield falls back to 0.5%. January 11, 2020: In a surprise twist, WikiLeaks reveals that the CIA has found no credible evidence that Russia had any material influence over the 2016 elections, but that Putin has been trying to cultivate the impression that it did. The document disparagingly notes that "Putin has relished the U.S. media's characterization of him as a master political manipulator with global reach, when in fact he is just the ruler of an impoverished, demographically depleted, militarily overextended country." The Mueller probe fizzles out. January 27, 2020: Voting in the Democratic primaries begins. Kamala Harris, Elizabeth Warren, and Sherrod Brown lead a crowded field of hopefuls. Bernie Sanders and Joe Biden choose not to run. Brown enjoys the biggest lead against Trump in head-to-head polls, but his support among primary voters is weighed down by his status as a cisgendered white male. January 28, 2020: On the other side of the Atlantic, the U.K. holds another referendum - this one to ratify the separation agreement reached with the EU. The terms of the agreement are widely regarded as being highly unfavorable to the U.K. Prime Minister Corbyn, having formed a coalition government with the Liberal Democrats and the SNP following elections in late 2018, makes it clear that a rejection of the deal is tantamount to a vote to stay in the EU. With the British economy in the doldrums, 53% of voters reject the deal. The U.K. remains in the EU. EUR/GBP falls to 0.84. January 29, 2020: The Fed cuts rates by another 25 basis points. Hiking rates once per quarter was good enough when unemployment was falling. However, now that the economy is on the rocks, the Fed reverts to a more aggressive loosening cycle, cutting rates once per meeting. Even so, a growing chorus of voices both inside and outside the Fed argue that it is not doing enough. February 17, 2020: Kamala Harris and Elizabeth Warren pull out ahead in the Democratic primaries. Similar to the Clinton/Sanders duel in 2016, Warren polls best among younger, whiter voters, while Harris leads among minorities and establishment Democrats. March 10, 2020: Donald Trump, seeing his poll numbers tank after the post-Korea bump, unilaterally raises trade barriers across a wide variety of industries. Foreign producers retaliate, leading to a contraction in global trade. April 26, 2020: Warren's relentless characterization of Harris as a shill for moneyed interests pays off. The Massachusetts senator secures the Democratic nomination. Hollywood celebrities line up to support Warren. Taylor Swift's silence on the matter is deafening, leading to a further increase in her album sales. June 5, 2020: The U.S. unemployment rate surges to 5.1%. Corporate America sees a wave of business closings, with the retail sector being particularly badly hit. July 21, 2020: The bellwether German IFO index falls to a multi-year low. Germany's manufacturing sector feels the pinch from the collapse in demand for capital equipment, especially from emerging markets. Merkel's popularity plummets after it is revealed that she tried to suppress data that more than half of asylum seekers classified as children were actually adults. Support for the Alternative for Deutschland Party, which by this time has greatly moderated its anti-EU rhetoric, rises sharply. August 17, 2020: The trade-weighted yen continues to strengthen, pushing Japan deeper into recession. In response, the Japanese government announces a major new stimulus package. In the clearest attempt yet to link fiscal with monetary policy, the authorities pledge to start issuing consumption vouchers to households, the value of which will be incrementally increased until long-term inflation expectations rise to the Bank of Japan's 2% target. The policy proves to be a smashing success. September 9, 2020: The U.S. presidential campaign ends up being even more divisive than the one in 2016. Unlike four years earlier, equities rally at any glimmer of hope that Trump will win. However, with unemployment rising, such moments prove few and far between. September 22, 2020: Senator Warren states on the campaign trail that she will not renominate Jay Powell in 2022 for a second term as Fed chair if she is elected president. Lael Brainard's name is floated as a likely replacement. V. The Return Of Stagflation October 13, 2020: Green shoots appear in the U.S. economy, marking the end of the recession. The unemployment rate rises for another two months, peaking at 6.8% in December. Other economies also begin to turn the corner. November 3, 2020: The tentative improvement in U.S. economic data happens too late to bail out Trump. Elizabeth Warren wins the presidential election. Warren loses Ohio but picks up Pennsylvania, Michigan, and Wisconsin. An influx of Democratic voters from Puerto Rico puts her over the top in Florida. The Democrats take back control of the Senate. November 4, 2020: The S&P 500 barely moves the day after the election, having already priced in the outcome months earlier. Still, at 2085, the index is 26% below its February 2019 peak. December 2, 2020: President-elect Warren pledges to introduce a major spending package after she is inaugurated. She brushes off concerns from some economists that fiscal stimulus is coming too late, noting that the unemployment rate is more than three points higher than it was one year earlier. Stocks rally on the news. January 27, 2021: The FOMC votes to keep rates on hold at 1%. Lael Brainard dissents, arguing that further monetary stimulus is necessary. March 19, 2021: The Chinese government shifts more bad loans from commercial banks into specially-designed state-owned asset management companies. The banks generally receive well above-market prices for their loans. Chinese bank shares move higher. April 2, 2021: Congress proposes to significantly raise taxes on higher-income earners and corporations with more than 500 employees and use the proceeds to fund an expansion of the Affordable Care Act. It also promises to introduces a "Tobin tax" on financial transactions. The post-election stock market rally fades. June 8, 2021: In a seminal speech, Lael Brainard argues that current inflation measures fail to adequately correct for technological improvements and other methodological issues. She suggests that this leads to an overstatement of the true level of inflation. The implication, she concludes, is that an inflation target of 2.5%-to-3% would be consistent with the Fed's existing mandate. September 24, 2021: Many Trump-era deregulation measures are rolled back. Anti-trust efforts are also ramped up. Despite an improving economy, the S&P 500 sinks to 2031, marking a five-year low. November 17, 2021: A wave of panic selling grips Wall Street. The S&P 500 crashes to 1969, down 31% from its February 2019 peak. As is often the case, this marks the bottom of the equity bear market. The subsequent recovery, however, proves to be tepid and prone to numerous setbacks. January 31, 2022: Thanks to ample fiscal stimulus, inflation in Japan rebounds from its recession lows. Aggregate income growth slows as more Japanese workers exit the labor force, but spending holds up as health care expenditures continue to climb. Japan's current account moves into a structural deficit position. February 16, 2022: Lael Brainard succeeds Jay Powell as Fed chair. The decision by Republicans in 2013 to reduce the number of senators necessary to approve appointments to the Fed board from 60 to 51 ensures smooth sailing for Brainard during congressional hearings and the confirmation of a slew of highly dovish candidates over the subsequent two years. April 6, 2022: China belatedly introduces modest financial incentives to encourage couples to have more children. The public jokingly dubs this as the new "at least one child policy". It ends up having little effect. Future Chinese scholars will end up describing China's failure to arrest the decline in its population as its greatest geopolitical blunder. July 20, 2022: The U.S. becomes the latest country to introduce strict restrictions on the use of bitcoin. Although the U.S. government never says so, fears that bitcoin and other cryptocurrencies will eat into the $75 billion in seigniorage revenue that the Treasury earns every year underpins the decision. The price of bitcoin falls to $550, down 95% from its all-time high. September 29, 2022: Japan officially abandons its yield-curve targeting regime. The 30-year yield rises to 2.5%. Faced with onerous long-term debt-servicing costs and stagnant tax revenues, the government starts refinancing much more of its debt through short-term borrowings. The Bank of Japan obliges, keeping short-term rates near zero. The combination of negative short-term real rates and higher inflation allows Japan to reduce its debt-to-GDP ratio over time. This proves to be the modus operandi for Japan and many other fiscally-challenged governments over the coming decades. October 18, 2022: Productivity growth in most developed economies continues to disappoint. For the first time in modern history, the flow of new workers entering the labor force are no better skilled or educated than the ones leaving. With potential GDP growing at a lackluster pace, output gaps disappear, setting in motion the acceleration in inflation over the remainder of the decade. The U.S. 10-year Treasury yield rises to 4%. It will be over 6% by the middle of the decade. November 22, 2022: The price of gold surpasses its previous high of $1895/oz. The 2020s turn out to be an excellent decade for bullion. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Chart 1Market Outlook: Equities Chart 2Market Outlook: Bonds Chart 3Market Outlook: Currencies Chart 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Agricultural markets are informationally efficient for the most part, which is to say that at any given time, prices already reflect most public information available to traders, and a lot of private information as well. Even so, we believe markets are underestimating the Fed's resolve in normalizing interest-rate policy next year - particularly when it comes to the number of rate hikes we are likely to see - and thus are underestimating the likelihood of lower grain prices in 2018. Energy: Overweight. Oil markets will emerge from their suspended animation following OPEC 2.0's Vienna meeting today. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 50.2%. Our long Jul/18 WTI vs. short Dec/18 WTI trade anticipating steepening backwardation is up 13.3%. Base Metals: Neutral. China's refined zinc imports were up 145% yoy to 61,355 MT in October, based on customs data. Metal Bulletin noted tight domestic supplies accounted for the increase. Precious Metals: Neutral. Gold is breaking away from its attachment to $1,280/oz., as the USD weakens. Our long gold portfolio hedge is up 5.2% since inception May 4, 2017. Ags/Softs: Neutral. Global financial conditions will become increasingly important to grain prices going forward, a trend we explore below. Feature Record output and ending stocks will ensure that ag markets remain well supplied globally next year. While we see risks as balanced in the upcoming year, and remain neutral ags generally, we believe markets are underestimating the Fed's resolve when it comes to normalizing interest rates, and thus underestimate upside USD potential. This means the likelihood of lower grain prices also is being underestimated. Weather will add volatility to the mix, as well. We believe the fundamentals supporting the assessment of record output and season-ending stocks-to-use ratios are fully reflected in prices. However, financial conditions - particularly USD strength next year - are not being fully priced by markets. This makes grains, in particular, vulnerable to the downside. Financial conditions driving ag markets: Fed policy & real rates: we expect U.S. financial conditions to tighten, and for the Fed to hike rates once more this year, and up to three more times in 2018.1 FX rates: With higher U.S. policy rates next year, the USD is likely to strengthen. This will weaken grain prices generally. Wheat, in particular, is most vulnerable to a strengthening USD and a weakening of the currencies of some of the commodity's top exporters - the European Union, Russia, and Australia. We've narrowed down the fundamental factors to look out for in 2018 as follows: Strong demand amid an extension of supply cuts by the OPEC 2.0 coalition will support oil prices in 2018. Higher energy prices will increase profit-margin pressure in ag markets through input and shipping costs. Weather risks from La Nina threaten to curb yields this winter, especially in Argentina and Brazil, which will add volatility to prices. Policy shifts in Argentina, China, and Brazil will influence farmers' planting decisions in the upcoming crop year. A Look Back At 2017 Chart of the WeekGrains Outperformed Softs This Year As predicted in our 2017 outlook, grains reversed their 2016 underperformance vis-à-vis softs this year, and outperformed them.2 While prices for sugar, coffee, and cotton were up 28%, 8%, and 12% in 2016, they have since declined by 21%, 8%, and 2%, respectively. In fact, sugar - our top ag in 2016 - took the biggest hit this year (Chart of the Week). On the other hand, as a complex, grains currently stand at largely the same level as the beginning of last year. However, there are some idiosyncrasies within the class. The two worst performing grains last year - rice and wheat - have been the strongest performers so far this year. Rice rallied 30% year-to-date (ytd) on the back of tighter supplies, completely reversing its 19% decline in 2016. Similarly, wheat, which lost 13% of its value last year, is up a modest 3% ytd. On the other hand, soybeans surrendered its title as the most profitable grain in 2016. After gaining 14% last year, its fate turned and it fell 3% ytd. Finally, out of the lot, corn is the only ag we cover that has fallen in both years consecutively, by a minor 1.9% in 2016, and an additional 4.4% so far this year. A Recap Of Long Term Trends According to the International Grains Council's November estimates, grains production is projected to come down this crop year. With an increase in consumption, this will ultimately lead to a 5.2% decline in ending stocks - the first drawdown in five years. Despite the year-on-year (y-o-y) decline, grain inventories are expected to stand at their second highest level on record (Table 1). Table 1Grain Production Down While Consumption Inches Higher The decline in expected grain ending stocks is mainly driven by corn, which - despite a large upwards revision to U.S. yields in the most recent WASDE - is expected to experience a 3.6% decline in production. This, together with a boost in consumption, leads to a 13.6% fall in ending stocks - the first drawdown since the 2010/11 crop year. The decline in corn expectations reflects a shift in the planting preferences of some of the major producers. The U.S., Brazil, Argentina, and China are the top soybean and corn exporters - accounting for 78% and 49% of global soybean and corn area harvested in the 2016/17 crop year, respectively. What is significant in the current cycle is that farmers in these countries are moving away from planting corn and towards more soybeans (Chart 2). China, which accounted for 19% of global corn area harvested and 6% of global soybean area harvested in 2016/17, is leading this change. While corn area harvested fell by an average 4.2% in the 2015 and 2016 crop years, soybean area harvested gained 9.8% during that period. Similarly, in Brazil, which accounted for 10% and 28% of global corn and soybean area harvested in 2016/17, respectively, corn area harvested by farmers has been growing at a much slower rate than soybean area harvested, with the former expanding by 16.4% and the latter by 39.6% since 2010/11. Likewise, harvested area in the U.S., which accounted for 18% and 29% of global corn and soybean area harvested, respectively, shrunk by 0.9% in the case of corn, and expanded by 21.3% in the case of soybeans since 2010/11. The exception to this rule is Argentina. Argentine farmland accounted for 3% and 15% of global corn and soybean area harvested in 2016/17, respectively. Since 2010/11, both corn area harvested as well as soybean area harvested increased by roughly the same level - 1.6 Mn Ha for the former and 1.5 Mn Ha for the latter - representing a 44.4% and 8.6% increase in area harvested for corn and soybeans, respectively. However, this is due to export policies, which in effect, encourage corn production over soybeans. As we discuss below, soybean export tariffs will be phased out in the coming years, likely changing the incentives structure for Argentine farmers. This trend is mirrored in production data, with global soybean output gaining 32% since 2010/11, compared to a 25% increase in global corn production. However, this shift is in large part due to demand patterns which also favor soybeans to corn. Over the same period, global soybean consumption increased by 36%, compared to 24% in the case of corn (Chart 3). Chart 2Farmers Favor Soybeans Over Corn... Chart 3...As Do Consumers In fact, at 28%, global soybean stock-to-use ratios are significantly more elevated than that of corn, which stand at 19%. Furthermore, while soybeans are expected to record a 3.9mm MT surplus by the end of the current crop year, corn is projected to experience a 17.7mm MT deficit. Powell's Fed And Dollar Movements Our modelling of ags reveals that U.S. financial factors are important determinants of agriculture commodity price developments.3 Fed policy decisions and their impact on real rates have a direct effect on ag commodity prices, as well as an indirect effect through the exchange rate channel (Chart 4). Chart 4Fed Policy Drives Ag Markets While U.S. inflation has remained stubbornly low, forcing the Fed to slow down their interest rate normalization process, the anticipation - and eventual acceleration - of the Fed tightening cycle will weigh on ag prices. However, thanks in part to softer-than-expected inflation readings coming out of the U.S. this year, the USD broad trade-weighted index (TWIB) has weakened by 6.8% since the beginning of the year. In terms of the impact of real rates, monetary policy impacts agriculture markets through the following channels: The Fed's interest-rate normalization process will, all else equal, increase borrowing costs for farmers, and discourage investments in general - impacting both agricultural investments as well as outlays in research and development. Tighter credit also leads to a slowdown in growth which - ceteris paribus - depresses consumption and demand for goods and services generally, and agricultural commodities specifically. Finally, real rates have an indirect effect on agricultural commodity prices through its effect on the U.S. dollar. Higher U.S. rates encourage investment in U.S. bonds and entail a strengthening of the U.S. dollar making U.S. exports less competitive vis-à-vis those of its international competitors. Since commodities are priced in U.S. dollars while costs are priced in local currencies, a weakening of the domestic currency vis-à-vis the dollar would increase profitability for farmers selling in international markets. This can incentivize farmers to plant more, despite depressed global ag prices, which increases supply. As our modelling reveals, the net effect is an inverse relationship, whereby easier monetary policy is generally more favorable for agriculture markets. The Fed Will Remain Behind The Inflation Curve Our U.S. Bond Strategy team expects the Fed to remain behind inflation, in which case the USD will remain weak in the beginning of next year. The 2/10 Treasury curve is flat highlighting the market's belief that the Fed will continue with interest rate normalization despite below target levels of inflation.4 Since this would be a huge error on the part of new Chairman Powell, our U.S. bond strategists believe that the Fed will avoid such a policy mistake. Consequently, if inflation does not pick up soon, the Fed will be forced to turn dovish. In any case, U.S. monetary policy will "fall behind the curve." This means that the U.S. dollar will remain weak until inflation starts to tick higher, and the Fed can resume its interest rate normalization process. In fact, our bond strategists find that there is a resemblance between the current cycle and that of the late 1990s where the unemployment rate significantly undershot its natural level before inflation started to accelerate. Thus, they find it significant that most of the indicators that predicted the 1999 increase in inflation are now positive. This reinforces our faith that inflation will soon rebound, allowing the Fed to fall behind the curve and simultaneously hike rates at a pace of one more hike this year, and three more in 2018.5 In terms of the future path of the U.S. dollar, our foreign exchange strategists argue interest rate differentials will be a more significant determinant of dollar dynamics going forward. They expect inflation will start its ascent sometime before the end of 1H2018, which would lift the interest rate curve and the dollar. Our expectation is that inflation will bottom towards the end of this year/beginning of next, giving room for the Fed to proceed with its anticipated rate-hiking cycle, resulting in two to three hikes next year. Markets are pricing one to two rate hikes next year, which means our out-of-consensus rates call could cause the USD to rally far more than what markets have priced in to the USD TWIB. Following a 4.4% appreciation in trade weighted terms in 2016, the U.S. dollar has depreciated by 6.8% so far this year. The U.S. accounts for a larger share of global exports of corn and soybeans than rice and wheat, which means a strengthening of the USD TWIB will likely have a bigger impact on wheat and rice, in which the U.S. faces greater international competition for market share (Table 2). Table 2Wheat & Rice Vulnerable To USD Dynamics This is, in fact, in line with the price behavior that we have observed. Wheat and rice prices fell the most in 2016 as the U.S. dollar appreciated, and have outperformed soybeans and corn so far this year, as the U.S. dollar depreciated. Thus, in the absence of supply shocks that affect a particular grain, changes in the U.S. dollar going forward will have a greater impact on rice and wheat than on corn and soybeans. Keep An Eye On The Brazilian Real Of the major ag exporters, Brazil is most vulnerable to USD depreciation risk. Poor productivity trends have made our foreign exchange strategists single out the Brazilian Real (BRL) as one of the most expensive currencies they track. While they expect the BRL to depreciate over a one- to two-year horizon, the current strength in EM asset prices means that the BRL is likely to remain at its current level in the near term. However, given that the BRL provides an high carry, it will likely move sideways until U.S. interest rate expectations adjust to a rebound in inflation - which we expect toward the end of this year, or beginning of next. Brazil is a major ag producer - making up 45%, 44%, 27%, 23% and 12% share of the global export pies for soybeans, sugar, coffee, corn and cotton, respectively. Thus, a weaker BRL vis-à-vis the USD is a major downside risk to these commodity prices. Downside FX Risks Will Keep Wheat Prices Depressed Chart 5Downside FX Risks For Wheat Exporters In addition to the risks from an overvalued BRL, our foreign exchange strategists have highlighted the EUR, RUB, and AUD as currencies that are at risk of falling back to their fair value in the near term. Given that these regions are major wheat exporters, this would weigh on the grain's price as exports increase (Chart 5).6 On the back of expectations that the European Central Bank will adopt a significantly less aggressive monetary policy than the Fed, our foreign exchange strategists expect the EUR to weaken toward the end of the year and beginning of next. Given that Europe is a major wheat exporter - making up ~20% of global exports - a weaker EUR would make European wheat more attractive, weighing on prices in 2018. The currencies of other major exporters could be drawn in different directions in the near term. Our FX strategists see the Russian Rouble (RUB) as overvalued and at risk of weakening when U.S. inflation starts accelerating late this year or early next. However, higher oil prices would push up the ruble's fair value, correcting some of its overvaluation. As with the EUR, the wheat market is most vulnerable to a weaker RUB since Russia accounts for 14% of global wheat exports. Likewise, Australia - another major wheat exporter which accounts for 10% of world exports - has been identified as having an expensive currency. It is at risk of a depreciation over the next 24 months, but could rally if iron ore markets turn higher. Some Additional (Potential) Fundamental Forces Among the news and noise in the ags sphere, we see higher oil prices and La Nina as the most significant near-term risks to current supply/demand dynamics. Longer term, shifting policies in China, Argentina, and Brazil will become more relevant in determining the trajectory of ag markets. Our Out-Of-Consensus Call On Oil Is Bullish For Ags Chart 6Higher Energy Prices Upside Risk We expect oil prices will tread higher next year - averaging $65/bbl for Brent and $63/bbl for WTI - on the back of stronger demand and an extension of the OPEC 2.0 coalition's supply restrictions.7 This will support ag commodity prices. Higher oil prices affect ags by increasing input costs and global shipping prices. In addition, the supply of ocean-going transport for grains is tight. The Baltic Dry index, a measure of the global cost of shipping dry goods, and has been on the uptrend this year, as freight costs have more than doubled since mid-February, mostly on the back of a slowdown in shipping transportation supply (Chart 6). La Nina: A Literal Tailwind? Against a backdrop of falling stocks-to-use ratios in the corn and soybean markets, weather will add volatility to prices into 1H2018. In the near term La Nina, which is predicted to continue through the 2017-18 Northern Hemisphere winter, threatens to curb agricultural output. This phenomenon affects weather and rainfall, causing floods and droughts, by cooling the Pacific Ocean. Australia's Bureau of Meteorology recently pegged the chance of a La Nina at 70%, expecting it to last from December to at least February. However, this season's La Nina is forecast to be weak and weather conditions are expected to neutralize in 1Q2018.8 In the case of ags, the greatest threat from La Nina is the risk of droughts in Brazil and Argentina which could hurt the regions soybean, corn, sugar, and cotton harvests. Furthermore, excess rainfall in Australia and Colombia threaten wheat, cotton, and sugar yields in the former and coffee output in the latter. Furthermore, the weather phenomenon raises chances of a potential drought in the U.S. Midwest.9 However, it is noteworthy that by the time La Nina hits, much of the harvest in the Northern Hemisphere will have been completed. So the main risk will be to harvests in the Southern Hemisphere. Gradualismo In Argentina, Stockpiling In China, And Ethanol In Brazil 1. Since taking office late 2015, Argentine President Mauricio Macri has reversed his predecessor's unfavorable agricultural policies - allowing the Argentine peso to float, and eliminating export taxes on wheat and corn. Marci's Gradualismo reforms have been successful - incentivizing plantings and leading to record harvests (Chart 7). While a 30% export tax remains on soybeans - Argentina's main cash crop - it is down from 35% under the presidency of Macri's predecessor. Further cuts to soybean export taxes have been delayed in order to finance the country's fiscal deficit, however they are expected to resume next year with a 0.5pp reduction/month for the next two years. This would stimulate soybean plantings, if it materializes. Argentine farmers produce 18% of global soybean output, and account for 9% of global soybean exports. The change in export policy, as it unfolds, will thus weigh on soybean prices as Argentine farmers increase their soybean acreage in the coming crop years. 2. Although we will likely get more clarity regarding Chinese ag policies with the release of China's Number 1 Central document - which for the past 14 years has focused on agriculture - in February, we expect Beijing to continue incentivizing soybean farming over corn. China's soybean inventory levels stand significantly lower than its notoriously massive stocks of corn, wheat, and cotton (Chart 8). Chart 7Argentine Reforms Will Raise Soybean Exports Chart 8China's Soybean Stocks Are Relatively Low As such, China's top corn producing province - Heilongjian - cut the subsidy for corn farmers by 13 percent this year. Farmers there now receive 8.90 yuan/hectare of corn, down from the 10.26 yuan/hectare they received last year. This compares with subsidies for soybean farmers which at 11.56 yuan/hectare is much higher. According to the China National Grain and Oils Information Center, corn acreage in Heilongjiang is down 9.3 percent in 2016/17. However, with corn prices in China increasing, the higher subsidy for soybeans may not be sufficient. Nonetheless, according to a report by the Brazilian state Mato Grosso's official news agency, over the next five years the Chinese commodities trader COFCO intends to almost double its soybean imports from the Brazilian grains state. This means that China's demand for soybeans will drive the market in the near term as they look to buildup soybean reserves and bring down their corn stocks.10 Chart 9Higher Oil Prices Incentivize Ethanol Over Sugar 3. Ethanol Demand will raise the opportunity costs of bringing sugar and corn to market. In addition to the direct effect of higher oil prices on ag commodities in general, our forecast of increasing prices will pressure sugar prices indirectly through the ethanol channel in Brazil. Since July, Brazil's state-controlled oil company, Petrobras, has shifted its pricing policy allowing gasoline and diesel prices to follow those of international oil markets. As a result, the gasoline-ethanol price gap is widening.11 This will revive demand for the biofuel, which will cause mills to divert sugarcane away from the sweetener in favor of producing more ethanol (Chart 9). In fact, according to UNICA - the Brazilian sugarcane industry association - mills in the country's center-south region - from which 90% of Brazil's sugar output is derived - are favoring ethanol production over sugar. Data for the first half of October shows that 46.5% of sugarcane was diverted to producing sugar, down from 49.6% in the same period last year. However, in the near term, increased production from the EU amid their scrapping of domestic sugar production quotas will likely keep the global market in balance.12 Global sugar supply is forecast to remain strong on the back of supplies from Thailand, Europe and India. There are reports that ethanol producers in Brazil are evaluating the adoption of "corn-cane flex" ethanol plants.13 However this is a longer run risk which would increase demand for corn, and reduce demand for sugar. Bottom Line: Financial conditions will drive ag prices in 2018. The Fed's resolve to normalize interest rates - more so than markets expect - will keep a lid on prices. This will offset risks from higher energy prices. Nonetheless, some weather induced volatility is likely into 1Q2018. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 In fact, our Global Investment Strategists expect the Fed to hike rates in December 2017, and again four more times in 2018. Please see BCA Research's Global Investment Strategy Weekly Report titled "A Timeline For the Next Five Years: Part I," dated November 24, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "2017 Commodity Outlook: Grains & Softs," dated December 22, 2016, available at ces.bcaresearch.com. 3 A 1% move in the USD TWI is associated with a 1.4% change in the CCI Grains & Oilseed Index, in the opposite direction. Similarly, a 1pp move in 5-year real rates is associated with a 18% change in the CCI Grains & Oilseed Index, in the opposite direction. The adjusted R2 is 0.84. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary titled "Into The Fire," dated November 7, 2017, available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy Weekly Report titled "The Fed Will Fall Behind The Curve," dated October 24, 2017, available at usbs.bcaresearch.com. 6 Please see BCA Research's Foreign Exchange Strategy Weekly Report titled "Updating Our Long-Term Fair Value Models," dated September 15, 2017, available at fes.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Balances Continue To Point To Higher Prices," dated November 23, 2017, available at ces.bcaresearch.com. 8 El Nino/Southern Oscillation (ENSO) alternates between warm ("El Nino") and cool ("La Nina") phases, impacting global precipitation and temperatures. These episodes are identified by looking at temperatures in the "Nino region 3.4" whereby readings of at least 0.5 degrees Celsius above or below seasonal average for several months would qualify as an El Nino or La Nina. 9 La Nina is often associated with wet conditions in eastern Australia, Indonesia, the Philippines, Thailand, and South Asia. It usually leads to increased rainfall in northeastern Brazil, Colombia, and other northern parts of South America, and drier than normal conditions in Uruguay, parts of Argentina, coastal Ecuador and northwestern Peru. The effect on the U.S. and Canada tends to be milder since they are located further away from the heart of ENSO, on the other hand it has the greatest impact on countries around the Pacific and Indian Oceans. 10 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Ags in 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 11 Flex-fuel vehicles in Brazil means that ethanol demand is not constrained by a "blending wall". Thus ethanol is a substitute for gasoline- rather than a complement to, as in the U.S. 12 France, Belgium, Germany and Poland reportedly have the capacity to ramp up sugar beet production. 13 Please see "Brazil mills eye corn-cane flex plant to extend production cycle," dated November 7, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights When it meets in Vienna at the end of this month, OPEC 2.0 will look through the pipeline leaks in South Dakota, which are expected to take some 500k b/d of Canadian crude shipments to the U.S. off the market until repairs are done at the end of November. While this will provide an unexpected assist in draining U.S. inventories, it truly is a transitory event (no pun intended). The larger issue for prices is gauging market expectations going into the OPEC 2.0 meeting at the end of this month. We believe the market is giving high odds to the coalition extending its 1.8mm b/d production cut to cover all of 2018 at its Vienna meeting. This is without doubt the result of the synchronized messaging coming from the leaders of OPEC 2.0, the Kingdom of Saudi Arabia (KSA) and Russia. Based on our balances models, an extension of the cuts to end-June - our base case - will draw OECD stocks down below their five-year average by mid-2018 (Chart of the Week). An executed extension to end-December 2018 would produce even sharper draws. This leaves the only material risk to prices a failure to extend the cuts on Nov. 30, or a reduction in the cuts themselves. Of the two, a failure to extend the cuts is the only material downside risk we see going into the Vienna meetings. Should OPEC 2.0 fail to extend its production cuts at month-end, and cause the markets to sell, we would view it as a buying opportunity: a Mar/18 expiry runs counter to OPEC 2.0's strategy. Energy: Overweight. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 41.4%, since they were recommended in September and October. Our long Jul/18 WTI vs. short Dec/18 WTI trade initiated November 2, 2017 in expectation of steepening backwardation is up 27.7%. Base Metals: Neutral. A weaker USD is providing a tailwind for copper, which is up ~ 2% over the past week. Our U.S. Bond Strategy desk expects the Fed to remain behind the inflation curve, which will translate into lower real rates and continue to support base metals.1 Precious Metals: Neutral. Gold continues to trade on either side of $1,280/oz, hardly budging following the upheaval in KSA. U.S. financial conditions - particularly a weaker USD - are driving gold. Our long gold portfolio hedge is up 4.2% since inception May 4, 2017. Ags/Softs: Neutral. Updated projections of record-high yields from U.S. corn farmers is behind the upward revision to 2017/2018 corn ending stocks in the November WASDE. This led to a massive increase - by 7.56mm MT - in U.S. corn output, which was partially offset by an increase in expected world demand and a downward adjustment to global beginning stocks. Corn prices were down more than 3% in the week following the revisions, but have since regained 2.5%. Feature Markets appear to be pricing in an extension of OPEC 2.0's production cuts to end-2018 when the producer group meets in Vienna at the end of the month around OPEC's regularly scheduled meeting. Our updated balances suggest a sharp sell-off triggered by market disappointment in OPEC 2.0 would represent a buying opportunity, particularly in 2H18. We continue to expect Brent to average $65/bbl next year in our base case (OPEC 2.0 cuts extended to end-June), with WTI trading $2/bbl under that. An extension of OPEC 2.0's cuts to end-December could lift our 2018 Brent forecast as much as $5/bbl, although the Brent-WTI spread likely would widen to $4 to $5/bbl, if this occurs. We do not believe additional cuts are in the offing. Nor do we expect an even-more-dramatic announcement of cuts being extended beyond 2018. We are deliberately keeping our base case more conservative than the apparent market expectation of an extension to end-2018. This suggests markets will be disappointed with anything less than an extension of the OPEC 2.0 cuts to end-June. Given our balances modeling, we believe any disappointment in the market's expectation that leads to a sell-off would represent a buying opportunity, since a Mar/18 expiry – the current terminus of the OPEC 2.0 production cuts, defeats the coalition's strategy of reducing OECD inventories. Under our base case, inventories draw to their five-year average levels by mid-year 2018 (Chart of the Week). In our updated balances model, we have a 100k b/d downward revision in expected U.S. oil-shale output for 2018 tightening the supply side for next year. The U.S. EIA has repeatedly revised its historical estimated shale production lower in recent months, and late-2017 rig counts have deteriorated slightly, which have shifted our historical production curve lower as well. On the demand side, we expect growth of ~ 1.65mm b/d on average in 2017 - 18. These assumptions give an upward bias to our 2018 price forecasts for Brent and WTI crude oil (Chart 2). Chart of the WeekSupply-Demand Balances##BR##Point Toward Tight Markets Chart 2Balances Are Tightening,##BR##Giving An Upward Bias To Prices Inventory Draw Could Be Sharper Chart 3Extending OPEC 2.0 Cuts To End-December##BR##Will Result In Sharper Draws An extension of the OPEC 2.0 cuts to end-Dec/18 would translate to a deeper storage draw than our end-June base case expectation (Chart 3). The Keystone pipeline leaks referenced above also provide an unanticipated assist in drawing down inventories, by temporarily removing ~ 500k b/d from the market in the 2H of November. While we have modeled price-induced additions to U.S. shale-oil output next year in our base case, an extension of OPEC 2.0's cuts to end-December likely will accelerate this production increase as additional production is added in 2H18. This will tend to temper price hikes, but not arrest them, given the differential storage draws we expect of 127 mm bbls. As we have noted, an extension of the OPEC 2.0 production cuts to the end of 2018 could lift Brent and WTI prices by as much as $5/bbl. However, given the still-insufficient pipeline take-away in the U.S. shale basins, we would expect higher production would widen the Brent - WTI price spread to $4 to $5/bbl next year. Practically, if the extension of the production cuts pushes Brent to $70/bbl, we're more inclined to expect WTI prices to average ~ $65/bbl next year. EM Continues To Lead Growth In Oil Demand EM oil demand strength continues to be the dominant feature of the oil market this year, and, we expect, into next year. We are modeling a 1.13mm b/d and 1.22mm b/d increase in EM demand this year and next, respectively. This accounts for 75% and 77% percent of global growth in 2017 and 2018 (Table 1). DM demand, which we proxy with OECD oil consumption, is expected to average 47.5mm b/d over the two-year interval, an average gain of 490k b/d over the interval, vs. 1.18 mm b/d gain in EM oil demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) China and India account for slightly more than one-third of the 52mm b/d of consumption we are modeling for non-OECD demand over this period, and ~50% of the non-OECD demand growth from 2016 to 2018. The indicators we use to confirm or refute the demand trends we see - EM imports and global PMIs - continue to support the global-growth theme we've noted throughout the year, particularly in the EM markets (Charts 4 and 5). Chart 4EM Trade Volumes Remain Strong,##BR##Supporting The Global Growth Hypothesis Chart 5Global Manufacturing Activity##BR##Remains Robust Continue Watching The Fed EM oil demand and import volumes are highly dependent on Fed policy, which is of particular concern now, because the U.S. central bank is trying to carry out its rate-normalization policy (Chart 6). Still, as our colleagues on the U.S. Bond Strategy desk note, "To avoid policy failure the Fed must allow inflation to reach its 2% target before the onset of the next recession. This means it will soon fall behind the inflation curve." This will be bullish for trade, since as we've shown in the past, U.S. monetary policy has a huge effect on trade.2 For the near term - into 1H18 - fundamentals will dominate the evolution of price: Supply, demand and inventories will matter more than U.S. monetary policy effects on the USD and real rates. Nonetheless, should the hawks in the Fed carry the day, we would expect a strengthening of the USD, which, all else equal, would act as a headwind to oil prices next year. For the time being, a weaker USD is reinforcing stronger prices brought about by tighter fundamentals, particularly in the Brent market (Chart 7). Chart 6Continue Watching The Fed Chart 7A Weaker USD Provides A Slight Tailwind Bottom Line: Markets are expecting OPEC 2.0 to extend its 1.8mm b/d production cut to end-2018. We are deliberately using a more conservative extension to end-June in our balances modeling, which produce 2018 Brent and WTI prices forecasts of $65/bbl and $63/bbl. An executed extension of the OPEC 2.0 cuts to end-December 2018 likely would add as much as $5/bbl to Brent prices, and perhaps $2/bbl to WTI prices, which would widen the Brent - WTI spread to $4 to $5/bbl on average next year. Fundamentals will continue to dominate the evolution of prices into 2018 - supply growth (falling), demand growth (rising), and inventories (falling) will drive prices. For the moment a weaker USD is supportive for commodities generally, particularly oil and copper. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see "The Fed Will Fall Behind The Curve," published October 24, 2017, by BCA Research's U.S. Bond Strategy. It is available at usbs.bcaresearch.com. 2 Please see footnote 1 above. U.S. monetary policy effects on EM oil demand and trade volumes, and the feedback loop back to the key indicators used by the Fed, have been a recurrent theme in our research. Please see, e.g., "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. Our line of research recently found support in IMF research published earlier this month; please see "Global Trade and the Dollar," published by the IMF November 13, 2017. The IMF research is available at http://www.imf.org/en/Publications/WP/Issues/2017/11/13/Global-Trade-and-the-Dollar-45336?cid=em-COM-123-36197 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Trades Closed in 2017 Summary of Trades Closed in 2016
Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook. This year, Mr. X introduced us to his daughter, who we shall identify as Ms. X. She has many years of experience as a portfolio manager, initially in a wealth management firm, and subsequently in two major hedge funds. In 2017, she joined her father to help him run the family office portfolio. She took an active role in our recent discussion and this report is an edited transcript of our conversation. Mr. X: As always, it is a great pleasure to sit down with you to discuss the economic and investment outlook. And I am thrilled to bring my daughter to the meeting. She and I do not always agree on the market outlook and appropriate investment strategy, but even in her first year working with me she has added tremendous value to our decisions and performance. As you know, I have a very conservative bias in my approach and this means I sometimes miss out on opportunities. My daughter is more willing than me to take risks, so we make a good team. I am happy that our investment portfolio has performed well over the past year, but am puzzled by the high level of investor complacency. I can't understand why investors do not share my concerns about by sky-high valuations, a volatile geopolitical environment and the considerable potential for financial instability. Over the years, you have made me appreciate the power of easy money to create financial bubbles and also that market overshoots can last for a surprisingly long time. Thus, I am fully aware that we could easily have another year of strong gains, but were that to happen, I would worry about the potential for a sudden 1987-style crash. I remember that event well and it was an unpleasant experience. My inclination is to move right now to an underweight equity position. Ms. X: Let me add that I am delighted to finally attend the annual BCA meeting with my father. Over the years, he has talked to me at length about your discussions, making me very jealous that I was not there. He and I do frequently disagree about the outlook so it will be good to have BCA's independent and objective perspective. As my father noted, I do not always share his cautious bias. When I joined the family firm in early 2017, I persuaded him to raise our equity exposure and that was the right decision. I have been in the business long enough to know that it is dangerous to get more bullish as the market rises and I agree there probably is too much complacency. However, I do not see an early end to the conditions that are driving the bull market and I am inclined to stay overweight equities for a while longer. Thus, the big debate between us is whether or not we should now book profits from the past year's strong performance and move to an underweight stance in risk assets. Hopefully, this meeting will help us make the right decision. Chart 1An Impressive Bull Market BCA: First of all, we are delighted to see you both and look forward to getting to know Ms. X in the years to come. It is not a surprise that you are debating whether to cut exposure to risk assets because that question is on the mind of many of our clients. We share your surprise about complacency - investors have been seduced by the relentless upward drift of prices since early 2016. The global equity index has not suffered any setback above 2% during the past year, and that has to be close to a record (Chart 1). The conditions that have underpinned this remarkable performance are indeed still in place but we expect that to change during the coming year. Thus, if equity prices continue to rise, it would make sense to reduce exposure to risk assets to a neutral position over the next few months. A blow-off phase with a final spike in prices cannot be ruled out, but trying to catch those moves is a very high-risk strategy. We are not yet recommending underweight positions in risk assets, but if our economic and policy views pan out, we likely will shift in that direction in the second half of 2018. Ms. X: It seems that you are siding with my father in terms of wanting to scale back exposure to risk assets. That would be premature in my view and I look forward to discussing this in more detail. But first, I would be interested in reviewing your forecasts from last year. BCA: Of course. A year ago, our key conclusions were that: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time lags in implementing policy mean that the fiscal plans of President-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. The key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given President-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. The most important prediction that we got right was our view that conditions were ripe for an overshoot in equity prices. The MSCI all-country index has delivered an impressive total return of around 20% in dollar terms since the end of 2016, one of the best calendar year performances of the current cycle (Table 1). So it was good that your daughter persuaded you to keep a healthy equity exposure. It is all the more impressive that the market powered ahead in the face of all the concerns that you noted earlier. Our preference for European markets over the U.S. worked out well in common currency terms, but only because the dollar declined. Emerging markets did much better than we expected, with significant outperformance relative to their developed counterparts. Table 1Market Performance With regard to the overall economic environment, we were correct in forecasting a modest improvement in 2017 global economic activity and that growth would not fall short of the IMF's predictions for the first time in the current expansion. However, one big surprise, not only for us, but also for policymakers, was that inflation drifted lower in the major economies. Latest data show the core inflation rate for the G7 economies is running at only 1.4%, down from 1.6% at the end of 2016. We will return to this critical issue later as the trend in inflation outlook will be a key determinant of the market outlook for the coming year and beyond. Regionally, the Euro area and Japanese economies registered the biggest upside surprises relative to our forecast and those of the IMF (Table 2). That goes a long way to explaining why the U.S. dollar was weaker than we expected. In addition, the dollar was not helped by a market downgrading of the scale and timing of U.S. fiscal stimulus. Nonetheless, it is worth noting that the dollar has merely unwound the 2016 Trump rally and recently has shown some renewed strength. Table 2IMF Economic Forecasts A year ago, there were major concerns about potential political turmoil from important elections in Europe, the risk of U.S.-led trade wars and a credit bust-up in China. We downplayed these issues as near-term threats to the markets and that turned out to be appropriate. Nevertheless, there are many lingering risks to the outlook and market complacency is a much bigger concern now than it was a year ago. Mr. X: As you just noted, a key theme of your Outlook last year was "Shifting Regimes" such as the end of disinflation and fiscal conservatism, a retreat from globalization, and the start of a rebalancing in income shares away from profits toward labor. And of course, you talked about the End of the Debt Supercycle a few years ago. Do you still have confidence that these regime shifts are underway? BCA: Absolutely! These are all trends that we expect to play out over a number of years and thus can't be judged by short-term developments. There have been particularly important shifts in the policy environment. The 2007-09 economic and financial meltdown led central banks to fight deflation rather than inflation and we would not bet against them in this battle. Inflation has been lower than expected, but there has been a clear turning point. On fiscal policy, governments have largely given up on austerity against a background of a disappointingly slow economic recovery in recent years and rising populist pressures (Chart 2). The U.S. budget deficit could rise particularly sharply over the next few years. In the U.S., the relative income shares going to profits and labor have started to shift direction, but there is a long way to go. Finally, the same forces driving government to loosen fiscal purse strings have also undermined support for globalization with the U.S. even threatening to abandon NAFTA. The ratio of global trade to output has trended sideways for several years and is unlikely to turn higher any time soon. All these trends are part of our Regime Shift thesis. Chart 2Regime Shifts The remarkable macro backdrop of low inflation, easy money and healthy profits has been incredibly positive for financial markets in recent years. You would have to be an extreme optimist to believe that such an environment will persist. Our big concern for the coming year is that we are setting up for a collision between the markets and looming changes in economic policy. The Coming Collision Between Policy And The Markets BCA: As you mentioned earlier, we attach enormous importance to the role of easy money in supporting asset prices and it is hard to imagine that we could have had a more stimulative monetary environment than has existed in recent years. Central banks have been in panic mode since the 2007-09 downturn with an unprecedented period of negative real interest rates in the advanced economies, coupled with an extraordinary expansion of central bank balance sheets (Chart 3). Initially, the fear was for another Great Depression and as that threat receded, the focus switched to getting inflation back to the 2% target favored by most developed countries. In a post-Debt Supercycle world, negative real rates have failed to trigger the typical rebound in credit demand that was so characteristic of the pre-downturn era. Central banks have expanded base money in the form of bank reserves, but this has not translated into markedly faster growth in broad money or nominal GDP. This is highlighted by the collapse in money multipliers (the ratio of broad to base money) and in velocity (the ratio of GDP to broad money). This has been a double whammy: there is less broad money generated for each dollar of base money and less GDP for every dollar of broad money (Chart 4). Chart 3An Extraordinary Period Of Easy Money Chart 4Monetary Policy: Pushing On A String Historically, monetary policy acted primarily through the credit channel with lower rates making households and companies more willing to borrow, and lenders more willing to supply funds. In the post-Debt Supercycle world, the credit channel has become partly blocked, forcing policymakers to rely more on the other channels of monetary transmission, the main one being boosting asset prices. However, there is a limit to how far this can go because the end result is massively overvalued assets and building financial excesses. The Fed and many other central banks now realize that this strategy cannot be pushed much further. The economic recovery in the U.S. and other developed economies has been the weakest of the post-WWII period. But potential growth rates also have slowed which means that spare capacity has gradually been absorbed. According to the IMF, the U.S. output gap closed in 2015 having been as high as 2% of potential GDP in 2013. The IMF estimates that the economy was operating slightly above potential in 2017 with a further rise forecast in 2018 (Chart 5). According to IMF estimates, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018 (i.e. they will be operating above potential). This makes it hard to justify the maintenance of hyper-stimulative monetary policies. Chart 5No More Output Gaps The low U.S. inflation rate is giving the Fed the luxury of moving cautiously and that is keeping the markets buoyant. Indeed, the markets don't even believe the Fed will be able to raise rates as much they expect. The most recent FOMC projections show a median federal funds rate of 2.1% by the end of 2018 but the markets are discounting a move to only 1.8%. The markets probably have this wrong because inflation is likely to wake up from its slumber in the second half of the year. Ms. X: This is another area where my father and I disagree. I view the world as essentially deflationary. We all know that technological innovations have opened up competition in a lot of markets, driving down prices. Two obvious examples are Uber and Airbnb, but these are just the tip of the iceberg. Amazon's purchase of Whole Foods is another example of how increased competitive pressures will continue to sweep through previously relatively stable industries. And such changes have an important impact on employee psychology and thus bargaining power. These days, people are glad to just keep their jobs and this means companies hold the upper hand when it comes to wage negotiations. So I don't see a pickup in inflation being a threat to the markets any time soon. Mr. X: I have a different perspective. First of all, I do not even believe the official inflation data because most of the things I buy have risen a lot in price over the past couple of years. Secondly, given the extremely stimulative stance of monetary policy in recent years, a pickup in inflation would not surprise me at all. So I am sympathetic to the BCA view. But, even if the data is correct, why have inflation forecasts proved so wrong and what underpins your view that it will increase in the coming year? BCA: There is an interesting disconnect between the official data and the inflation views of many consumers and economic/statistics experts. According to the Conference Board, U.S. consumers' one-year ahead inflation expectations have persistently exceeded the published data and the latest reading is close to 5% (Chart 6). That ties in with your perception. Consumer surveys by the New York Fed and University of Michigan have year-ahead inflation expectations at a more reasonable 2.5%. At the same time, many "experts" believe the official data is overstated because it fails to take enough account of technological changes and new lower-priced goods and services. The markets also have a moderately optimistic view with the five-year CPI swap rate at 2%. This is optimistic because it is consistent with inflation below the Fed's 2% target, if one allows for an inflation risk premium built in to the swap price. We are prepared to take the inflation data broadly at face value. Low inflation is consistent with an ongoing tough competitive environment in most sectors, boosted by the disruptive impact of technological changes that Ms. X described. The inflation rate for core goods (ex-food and energy) has been in negative territory for several years while that for services ex-shelter is at the low end of its historical range (Chart 7). Chart 6Differing Perspectives Of Inflation Chart 7Not Much Inflation Here There is no simple explanation of why inflation has fallen short of forecasts. Economic theory assumes that price pressures build as an economy moves closer to full employment and the U.S. is at that point. This raises several possibilities: There is more slack in the economy than suggested by the low unemployment rate. The lags are unusually long in the current cycle. Technological disruption is having a greater impact than expected. The link between economic slack and inflationary pressures is typically captured by the Phillips Curve which shows the relationship between the unemployment rate and inflation. In the U.S., the current unemployment rate of 4.1% is believed to be very close to a full-employment level. Yet, inflation recently has trended lower and while wage growth is in an uptrend, it has remained softer than expected (Chart 8). Chart 8Inflationary Pressures Are Turning We agree with Ms. X that employee bargaining power has been undermined over the years by globalization and technological change and by the impact of the 2007-09 economic downturn. That would certainly explain a weakened relationship between the unemployment rate and wage growth, but does not completely negate the theory. The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. As far as the impact of technology is concerned, there is no doubt that innovations like Uber and Airbnb are deflationary. However, our analysis suggests that the growth in online spending has not had a major impact on the inflation numbers. E-commerce still represents a small fraction of total U.S. consumer spending, depressing overall consumer inflation by only 0.1 to 0.2 percentage points. The deceleration of inflation since the global financial crisis has been in areas largely unaffected by online sales, such as energy and rent. Moreover, today's creative destruction in the retail sector is no more deflationary than the earlier shift to 'big box' stores. We are not looking for a dramatic acceleration in either wage growth or inflation - just enough to convince the Fed that it needs to carry on with its plan to raise interest rates. And the pressure to do this will increase if the Administration is able to deliver on its planned tax cuts. Ms. X: You make it sound as if cutting taxes would be a bad thing. Surely the U.S. would benefit from the Administration's tax plan? A reduction in the corporate tax rate would be very bullish for equities. BCA: The U.S. tax system is desperately in need of reform via eliminating loopholes and distortions and using the savings to lower marginal rates. That would make it more efficient and hopefully boost the supply side of the economy without undermining revenues. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. Importantly, there is not a strong case for personal tax cuts given that a married worker on the average wage and with two children paid an average income tax rate of only 14% in 2016, according to OECD calculations. There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. The combination of easier fiscal policy and Fed rate hikes will be bullish for the dollar and this will contribute to tighter overall financial conditions. That is why we see a coming collision between economic policy and the markets. The narrative for the so-called Trump rally in markets was based on the assumption that the Administration's platform of increased spending, tax cuts and reduced regulations would be bullish for the economy and thus risk assets. That was always a misplaced notion. The perfect environment for markets has been moderate economic growth, low inflation and easy money. The Trump agenda would be appropriate for an economy that had a lot of spare capacity and needed a big boost in demand. It is less suited for an economy with little spare capacity. Reduced regulations and lower corporate tax rates are good for the supply side of the economy and could boost the potential growth rate. However, if a key move is large personal tax cuts then the boost to demand will dominate. Mr. X: It seems that you are making the case for a serious policy error in the U.S. in the coming year - both on fiscal and monetary policy. I can't argue against that because everything that has happened over the past few years tells me that policymakers don't have a good grip on either the economy or the implications of their actions. I never believed that printing money and creating financial bubbles was a sensible approach to an over-indebted economy. I always expected it to end badly. BCA: Major tightening cycles frequently end in recession because monetary policy is a very blunt tool. Central banks would like to raise rates by just enough to cool things down but that is hard to achieve. The problem with fiscal policy is that implementation lags mean that it often is pro-cyclical. In other words, there is pressure for fiscal stimulus in a downturn, but by the time legislation is passed, the economy typically has already recovered and does not really need a big fiscal boost. And that certainly applies to the current environment. The other area of potential policy error is on trade. Having already pulled the U.S. out of the Trans-Pacific Partnership, the Trump Administration is taking a hardline attitude toward a renegotiation of NAFTA. This could even end up with the deal being scrapped and that would add another element of risk to the North American economies. Ms. X: Your scenario assumes that the Fed will be quite hawkish. However, everything I have read about Jerome Powell, the new Fed chair, suggests that he will err on the side of caution when it comes to raising rates. So monetary policy may not collide with markets at all over the coming year. BCA: It is certainly true that Powell does not have any particular bias when it comes to the conduct of monetary policy. That would not have been the case if either John Taylor or Kevin Warsh had been given the job - they both have a hawkish bias. Powell is not an economist so will likely follow a middle path and be heavily influenced by the Fed's staff forecasts and by the opinions of other FOMC members. There are still several vacancies on the Fed's Board so much will depend on who is appointed to those positions. The latest FOMC forecasts are for growth and inflation of only 2% in 2018 and these numbers seem too low. Meanwhile, the prediction that unemployment will still be at 4.1% at end-2018 is too high. We expect projections of growth and inflation to be revised up and unemployment to be revised down. That will embolden the Fed to keep raising rates. So, even with Powell at the helm, monetary policy is set to get tighter than the market currently expects. Ms. X: So far, we have talked mainly about the U.S. What about other central banks? I can't believe that inflation will be much of a problem in the euro area or in Japan any time soon. Does that not mean that the overall global monetary environment will stay favorable for risk assets? BCA: The Fed is at the leading edge of the shift away from extreme monetary ease by hiking interest rates and starting the process of balance sheet reduction. But the Bank of Canada also has raised rates and the ECB has announced that it will cut its asset purchases in half beginning January 2018, as a first step in normalizing policy. Even the Bank of England has raised rates despite Brexit-related downside risks for the economy. The BoJ will keep an accommodative stance for the foreseeable future. You are correct that financial conditions will be tightening more in the U.S. than in other developed economies. Moreover, equity valuations are more stretched in the U.S. than elsewhere leaving that market especially vulnerable. Yet, market correlations are such that any sell-off in U.S. risk assets is likely to become a global affair. Another key issue relates to the potential for financial shocks. Long periods of extreme monetary ease always fuel excesses and sometimes these remain hidden until they blow up. We know that companies have taken on a lot of debt, largely to fund financial transactions such as share buybacks and merger and acquisitions activity. That is unlikely to be the direct cause of a financial accident but might well become a problem in the next downturn. It typically is increased leverage within the financial sector itself that poses the greatest risk and that is very opaque. The banking system is much better capitalized than before the 2007-09 downturn so the risks lie elsewhere. As would be expected, margin debt has climbed higher with the equity market, and is at a historically high level relative to market capitalization (Chart 9). We don't have good data on the degree of leverage among non-bank financial institutions such as hedge funds but that is where leverage surprises are likely to occur. And the level of interest rates that causes financial stress is almost certainly to be a lot lower than in the past. Chart 9Financial Leverage Has Risen Mr. X: That is the perfect lead-in to my perennial concern - the high level of debt in the major economies. I realize high debt levels are not a problem when interest rates are close to zero, but that will change if your view on the Fed is correct. Ms. X: I would just add that this is one area where I share my father's concerns, but with an important caveat. I wholeheartedly agree that high debt levels pose a threat to economic and financial stability, but I see this as a long-term issue. Even with rising interest rates, debt servicing costs will stay low for at least the next year. It seems to me that rates will have to rise a lot before debt levels in the major economies pose a serious threat to the system. Even if the Fed tightens policy in line with its plans, real short rates will still stay low by historical standards. This will not only keep debt financing manageable but will also sustain the search for yield and support equity prices. BCA: We would be disappointed if you both had not raised the issue of debt. Debt levels do indeed remain very elevated among advanced and emerging economies (Chart 10). The growth in private debt remains far below pre-crisis levels in the advanced countries, but this has been offset by the continued high level of government borrowing. As a result, the total debt-to-GDP ratio has stayed close to a peak. And both private and public debt ratios have climbed to new highs in the emerging economies, with China leading the charge. Chart 10ADebt Levels Remain Elevated Chart 10BDebt Levels Remain Elevated As we have discussed in the past, there is not an inconsistency between our End of Debt Supercycle thesis and the continued high levels of debt in most countries. As noted earlier, record-low interest rates have not triggered the kind of private credit resurgence that occurred in the pre-crisis period. For example, household borrowing has remained far below historical levels as a percent of income in the U.S., despite low borrowing costs (Chart 11). At the same time, it is not a surprise that debt-to-income ratios are high given the modest growth in nominal incomes in most countries. Chart 11Low Rates Have Not Triggered ##br##A Borrowing Surge In U.S. Debt growth is not benign everywhere. In the developed world, Canada's debt growth is worryingly high, both in the household and corporate sectors. As is also the case with Australia, Canada's overheated housing market has fueled rapid growth in mortgage debt. These are accidents waiting to happen when borrowing costs increase. In the emerging word, China has yet to see the end of its Debt Supercycle. Fortunately, with most banks under state control, the authorities should be able to contain any systemic risks, at least in the near run. With regard to timing, we agree that debt levels are not likely to pose an economic or financial problem in next year. It is right to point out that debt-servicing costs are very low by historical standards and it will take time for rising rates to have an impact given that a lot of debt is locked in at low rates. For example, in the U.S., the ratio of household debt-servicing to income and the non-financial business sector's ratio of interest payments to EBITD are at relatively benign levels (Chart 12). However, changes occur at the margin and the example of the Bernanke taper tantrum highlighted investor sensitivity to even modest changes in the monetary environment. You may well be right Ms. X that risk assets will continue to climb higher in the face of a tighter financial conditions. But given elevated valuations, we lean toward a cautious rather than aggressive approach to strategy. We would rather leave some money on the table than risk being caught in a sudden downdraft. Other investors, including yourself, might prefer to wait for clearer signals that a turning point is imminent. Returning to the issue of indebtedness, the end-game for high debt levels continues to be a topic of intense interest. There really are only three options: to grow out of it, to write it off, or to try and inflate it away. The first option obviously would be best - to have fast enough growth in real incomes that allowed debtors to start paying down their debt. Unfortunately, that is the least likely prospect given adverse demographic trends throughout the developed world and disappointing productivity growth (Chart 13). Chart 12Borrowing Costs Are Benign Chart 13It's Hard To Grow Out Of Debt ##br##With These Structural Headwinds Writing the debt off - i.e. defaulting - is a desperate measure that would be the very last resort after all other approaches had failed. In this case, we are talking mainly about government debt, because private debt always has to be written off when borrowers become bankrupt. Japan is the one developed country where government debt probably will be written off eventually. Given that the Bank of Japan owns around 45% of outstanding government debt, those holdings can be neutralized by converting them to perpetuals - securities that are never redeemed. If the first two options are not viable, then inflation becomes the preferred solution to over-indebtedness. To make a big impact, inflation would need to rise far above the 2% level currently favored by central banks, and it would have to stay elevated for quite some time. Central banks are not yet ready to allow such an environment, but that could change after the next economic downturn. Central banks have made it clear that they are prepared to pursue radical policies in order to prevent deflation. This sets the scene for increasingly aggressive actions after the next recession and the end result could be a period of significantly higher inflation. Mr. X: I don't disagree with that view which is why I always like to hold some physical gold in my portfolio. It is interesting that you are worried about a looming setback for risk assets because you are positive on the near-run economic outlook. That is contrary to the typical view that sees a decent economy as supporting higher equity prices. Let's spend a bit more time on your view of the economic outlook. Ms. X: Before we do that, I would just emphasize that it is far too early to worry about debt end games and the potential for sharply rising inflation. I don't disagree that monetary policy could be forced to embrace massive reflation during the next downturn and perhaps that will make me change my view of the inflation outlook. But the sequencing is important because we would first have to deal with a recession that could be a very deflationary episode. And before the next recession we could have period of continued decent growth, which would be positive for risk assets. So I agree that the near-term view of the economic outlook is important. The Economic Outlook BCA: This recovery cycle has been characterized by a series of shocks and headwinds that constrained growth in various regions. In no particular order, these included fiscal austerity, the euro crisis, a brief U.S. government shutdown, the Japanese earthquake, and a spike in oil prices above $100. As we discussed a year ago, in the absence of any new shocks, we expected global growth to improve and that is what occurred in 2017. A broad range of indicators shows that activity has picked up steam in most areas. Purchasing managers' indexes are in an uptrend, business and consumer confidence are at cyclical highs and leading indicators have turned up (Chart 14). This is hardly a surprise given easy monetary conditions and a more relaxed fiscal stance almost everywhere. Chart 14Global Activity On An Uptrend The outlook for 2018 is positive and the IMF's projections for growth is probably too low (see Table 2). So, for the second year in a row, the next set of updates due in the spring are likely to be revised up. Ms. X: Let's talk about the U.S. economy. You are concerned that tax cuts could contribute to overheating, tighter monetary policy and an eventual collision with the markets. But there are two alternative scenarios, both quite optimistic for risk assets. On the one hand, a cut in the corporate tax rate could trigger a further improvement in business confidence and thus acceleration in capital spending. This would boost the supply side of the economy and mean that faster growth need not lead to higher inflation. It would be the perfect world of a low inflation boom. At the other extreme, if political gridlock prevents any meaningful tax cuts, we will be left with the status quo of moderate growth and low inflation that has been very positive for markets during the past several years. Mr. X: You can always rely on my daughter to emphasize the potential for optimistic outcomes. I would suggest another entirely different scenario. The cycle is very mature and I fear it would not take much to tip the economy into recession, even if we get some tax relief. So I am more concerned with near-term downside risks to the U.S. economy. A recession in the coming year would be catastrophic for the stock market in my view. BCA: Before we get to the outlook, let's agree on where we are right now. As we already noted, the U.S. economy currently is operating very close to its potential level. The Congressional Budget Office estimates potential growth to be only 1.6% a year at present, which explains why the unemployment rate has dropped even though growth has averaged a modest 2% pace in recent years. The consumer sector has generally been a source of stability with real spending growing at a 2¾% pace over the past several years (Chart 15). And, encouragingly, business investment has recently picked up from its earlier disappointing level. On the negative side, the recovery in housing has lost steam and government spending has been a source of drag. Looking ahead, the pattern of growth may change a bit. With regard to consumer spending, the pace of employment growth is more likely to slow than accelerate given the tight market and growing lack of available skilled employees. According to the National Federation of Independent Business survey, 88% of small companies hiring or trying to hire reported "few or no qualified applicants for the positions they were trying to fill". Companies in manufacturing and construction say that the difficulty in finding qualified workers is their single biggest problem, beating taxes and regulations. In addition, we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 16). On the other hand, wage growth should continue to firm and there is the prospect of tax cuts. Overall, this suggests that consumer spending should continue to grow by at least a 2% pace in 2018. Chart 15Trends In U.S. Growth Chart 16Personal Saving At A Recovery Low Survey data suggests that business investment spending should remain strong in the coming year, even without any additional boost from corporate tax cuts. Meanwhile, rebuilding and renovations in the wake of Hurricanes Harvey and Irma should provide a short-term boost to housing investment and a more lasting improvement will occur if the millennial generation finally moves out of their parents' basements. On that note, it is encouraging that the 10-year slide in the homeownership rate appears to have run its course (Chart 17). And although housing affordability is down from its peak, it remains at an attractive level from a historical perspective. Chart 17A Weak Housing Recovery Last, but not least, government spending will face countervailing forces. The Administration plans to increase spending on defense and infrastructure but there could be some offsetting cutbacks in other areas. Overall, government spending should make a positive contribution to 2018 after being a drag in 2017. Putting all this together, the U.S. economy should manage to sustain a growth rate of around 2.5% in 2018, putting GDP further above its potential level. And it could rise above that if tax cuts are at the higher end of the range. You suggested three alternative scenarios to our base case: a supply-side boom, continued moderate growth and a near-term recession. A supply-side revival that leads to strong growth and continued low inflation would be extremely bullish, but we are skeptical about that possibility. The revival in capital spending is good news, but this will take time to feed into faster productivity growth. Overall, any tax cuts will have a greater impact on demand than supply, putting even greater pressure on an already tight labor market. The second scenario of a continuation of the recent status quo is more possible, especially if we end up with a very watered-down tax package. However, growth would actually have to drop below 2% in order to prevent GDP from rising above potential. We will closely monitor leading indicators for signs that growth is about to lose momentum. The bearish scenario of a near-term recession cannot be completely discounted, but there currently is no compelling evidence of such a development. Recessions can arrive with little warning if there is an unanticipated shock, but that is rare. Historically, a flat or inverted yield curve has provided a warning sign ahead of most recessions and the curve currently is still positively sloped (Chart 18). Another leading indicator is when cyclical spending1 falls as a share of GDP, reflecting the increased sensitivity of those items to changes in financial conditions. Cyclical spending is still at a historically low level relative to GDP and we expect this to rise rather than fall over the coming quarters. While a near-term recession does not seem likely, the odds will change during the course of 2018. By late year, there is a good chance that the yield curve will be flat or inverted, giving a warning signal for a recession in 2019. Our base case view is for a U.S. recession to start in the second half of 2019, making the current expansion the longest on record. At this stage, it is too early to predict whether it would be a mild recession along the lines of 1990-91 and 2000-01 or a deeper downturn. Chart 18No Recession Signals For The U.S. ...Yet Mr. X: I hope that you are right that a U.S. recession is more than a year away. I am not entirely convinced but will keep an open mind, and my daughter will no doubt keep me fully informed of any positive trends. Ms. X: You can be sure of that. Although I lean toward the optimistic side on the U.S. economy, I have been rather surprised at how well the euro area economy has done in the past year. Latest data show that the euro area's real GDP increased by 2.5% in the year to 2017 Q3 compared to 2.3% for the U.S. Can that be sustained? BCA: The relative performance of the euro area economy has been even better if you allow for the fact that the region's population growth is 0.5% a year below that of the U.S. So the economic growth gap is even greater on a per capita basis. The euro area economy performed poorly during their sovereign debt crisis years of 2011-13, but the subsequent improvement has meant that the region's real per capita GDP has matched that of the U.S. over the past four years. And even Japan's GDP has not lagged much behind on a per capita basis (Chart 19). Chart 19No Clear Winner On Growth The recovery in the euro area has been broadly based but the big change was the end of a fiscal squeeze in the periphery countries. Between 2010 and 2013, fiscal drag (the change in the structural primary deficit) was equivalent to around 10% of GDP in Greece and Portugal and 7% of GDP in Ireland and Spain. There was little fiscal tightening in the subsequent three years, allowing those economies to recover lost ground. Meanwhile, Germany's economy has continued to power ahead, benefiting from much easier financial conditions than the economy has warranted. That has been the inevitable consequence of a one size fits all monetary policy that has had to accommodate the weakest members of the region. The French and Italian economies have disappointed, but there are hopes that the new French government will pursue pro-growth policies. And Italy should also pick up given signs that it is finally starting to deal with its fragile banking system. Both Spain and Italy faced a sharp rise in non-performing bank loans during the great recession, but Italy lagged Spain in dealing with the problem (Chart 20). That goes a long way to explaining why the Italian economic recovery has been so poor relative to Spain. With Italian banks raising capital and writing off non-performing loans more aggressively, the Italian economy should start to improve, finally catching up with the rest of the region. Overall, the euro area economy should manage to sustain growth above the 2.1% forecast by the IMF for 2018. Overall financial conditions are likely to stay favorable for at least another year and we do not anticipate any major changes in fiscal policy. If, as we fear, the U.S. moves into recession in 2019, there will be negative fallout for Europe, largely via the impact on financial markets. However, in relative terms, the euro area should outperform the U.S. during the next downturn. Mr. X: A year ago, you said that Brexit posed downside risks for the U.K. economy. For a while, that seemed too pessimistic as the economy performed quite well, but recent data show things have taken a turn for the worse. How do you see things playing out with this issue? BCA: It was apparent a year ago that the U.K. government had no concrete plans to deal with Brexit and little has changed since then. The negotiations with the EU are not going particularly well and the odds of a "hard" exit have risen. This means withdrawing from the EU without any agreement on a new regime for trade, labor movements or financial transactions. A growing number of firms are taking the precaution of shifting some operations from the U.K. to other EU countries. As you noted, there are signs that Brexit is starting to undermine the U.K. economy. For example, London house prices have turned down and the leading economic index has softened (Chart 21). The poor performance of U.K. consumer service and real estate equities relative to those of Germany suggest investors are becoming more wary of the U.K. outlook. Of course, a lot will depend on the nature of any deal between the U.K. and the EU and that remains a source of great uncertainty. Chart 20A Turning Point For Italian Banks? Chart 21U.K. Consumer Services Equities Are ##br##Underperforming Brexit Effects Show Up At the moment, there are no real grounds for optimism. The U.K. holds few cards in the bargaining process and the country's strong antipathy toward the free movement of people within the EU will be a big obstacle to an amicable separation agreement. Ms. X: I think the U.K. made the right decision to leave the EU and am more optimistic than you about the outlook. There may be some short-term disruption but the long-term outlook for the U.K. will be good once the country is freed from the stifling bureaucratic constraints of EU membership. The U.K. has a more dynamic economy than most EU members and it will be able to attract plenty of overseas capital if the government pursues appropriate policies toward taxes and regulations. It will take a few years to find out who is correct about this. In the meantime, given the uncertainties, I am inclined to have limited exposure to sterling and the U.K. equity market. Let's now talk about China, another country facing complex challenges. This is a topic where my father and I again have a lot of debates. As you might guess, I have been on the more optimistic side while he has sided with those who have feared a hard landing. And I know that similar debates have occurred in BCA. BCA: It is not a surprise that there are lots of debates about the China outlook. The country's impressive economic growth has been accompanied by an unprecedented build-up of debt and supply excesses in several sectors. The large imbalances would have led to a collapse by now in any other economy. However, China has benefited from the heavy state involvement in the economy and, in particular, the banking sector. The big question is whether the government has enough control over economic developments to avoid an economic and financial crisis. The good news is that China's government debt is relatively low, giving them the fiscal flexibility to write-off bad debts from zombie state-owned enterprises (SOEs). The problems of excessive leverage and over-capacity are particularly acute in SOEs that still comprise a large share of economic activity. The government is well aware of the need to reform SOEs and various measures have been announced, but progress has been relatively limited thus far. The IMF projects that the ratio of total non-financial debt to GDP will remain in an uptrend over the next several years, rising from 236% in 2016 to 298% by 2022 (Chart 22). Yet, growth is expected to slow only modestly over the period. Of course, one would not expect the IMF to build a crisis into their forecast. Some investors have been concerned that a peak in China's mini-cycle of the past two years may herald a return to the economic conditions that prevailed in 2015, when the industrial sector grew at a slower pace than during the acute phase of the global financial crisis. These conditions occurred due to the combination of excessively tight monetary conditions and weak global growth. While China's export growth may slow over the coming year, monetary policy remains accommodative. Monetary conditions appear to have peaked early this year but are still considerably easier than in mid-2015. Shifts in the monetary conditions index have done a good job of leading economic activity and they paint a reasonably positive picture (Chart 23). The industrial sector has finally moved out of deflation, with producer prices rising 6.9% in the year ended October. This has been accompanied by a solid revival in profits. Chart 22China: Debt-Fueled Growth To Continue Chart 23China Leaves Deflation Behind On balance, we assume that the Chinese economy will be able to muddle through for the foreseeable future. President Xi Jinping has strengthened his grip on power and he will go to great lengths to ensure that his reign is not sullied with an economic crisis. The longer-term outlook will depend on how far the government goes with reforms and deleveraging and we are keeping an open mind at this point. In sum, for the moment, we are siding with Ms. X on this issue. Mr. X: I have been too bearish on China for the past several years, but I still worry about the downside risks given the massive imbalances and excesses. I can't think of any example of a country achieving a soft landing after such a massive rise in debt. I will give you and my daughter the benefit of the doubt, but am not totally convinced that you will be right. BCA has been cautious on emerging economies in general: has that changed? BCA: The emerging world went through a tough time in 2015-16 with median growth of only 2.6% for the 23 constituent countries of the MSCI EM index (Chart 24). This recovered to 3% in 2017 according to IMF estimates, but that is still far below the average 5% pace of the period 2000-07. Chart 24Emerging Economy Growth: ##br##The Boom Years Are Over It is always dangerous to generalize about the emerging world because the group comprises economies with very different characteristics and growth drivers. Two of the largest countries - Brazil and Russia - went through particularly bad downturns in the past couple of years and those economies are now in a modest recovery. In contrast, India has continued to grow at a healthy albeit slowing pace, while Korea and the ASEAN region have not suffered much of a slowdown. If, as seems likely, Chinese growth holds above a 6% pace over the next year, then those countries with strong links to China should do fine. And it also points to reasonably steady commodity prices, supporting resource-dependent economies. Longer-run, there are reasons to be cautious about many emerging economies, particularly if the U.S. goes into recession 2019, as we fear. That would be associated with renewed weakness in commodity prices, and capital flight from those economies with high external debt such as Turkey and South Africa. As we stated a year ago, the heady days of emerging economy growth are in the past. Mr. X: It seems that both my daughter and I can find some areas of agreement with your views about the economic outlook. You share her expectation that the global growth outlook will stay healthy over the coming year, but you worry about a U.S.-led recession in 2019, something that I certainly sympathize with. But we differ on timing: I fear the downturn could occur even sooner and I know my daughter believes in a longer-lasting upturn. Let's now move onto what this all means for financial markets, starting with bonds. Bond Market Prospects Ms. X: I expect this to be a short discussion as I can see little attraction in bonds at current yields. Even though I expect inflation to stay muted, bonds offer no prospect of capital gains in the year ahead and even the running yield offers little advantage over the equity dividend yield. BCA: As you know, we have believed for some time that the secular bull market in bonds has ended. We expect yields to be under upward pressure in most major markets during 2018 and thus share your view that equities offer better return prospects. By late 2018, it might well be appropriate to switch back into bonds against a backdrop of higher yields and a likely bear market in equities. For the moment, we recommend underweight bond exposure. It is hard to like government bonds when the yield on 10-year U.S. Treasuries is less than 50 basis points above the dividend yield of the S&P 500 while the euro area bond yield is 260 basis points below divided yields (Chart 25). Real yields, using the 10-year CPI swap rate as a measure of inflation expectations, are less than 20 basis points in the U.S. and a negative 113 basis points in the euro area. Even if we did not expect inflation to rise, it would be difficult to recommend an overweight position in any developed country government bonds. One measure of valuation is to compare the level of real yields to their historical average, adjusted by the standard deviation of the gap. On this basis, the most overvalued markets are the core euro area countries, where real yields are 1.5 to 2 standard deviations below their historical average (Chart 26). There are only two developed bond markets where real 10-year government yields currently are above their historical average: Greece and Portugal. This is warranted in Greece where there needs to be a risk premium in case the country is forced to leave the single currency at some point. This is less of a risk for Portugal, making it a more interesting market. Real yields in New Zealand are broadly in line with their historical average, also making it one of the more attractive markets. Chart 25Bonds Yields Offer Little Appeal Chart 26Valuation Ranking Of Developed Bond Markets Mr. X: Given your expectation of higher inflation, would you recommend inflation-protected Treasuries? BCA: Yes, in the sense that they should outperform conventional Treasuries. The 10-year TIPS are discounting average inflation of 1.85% and we would expect this to be revised up during the coming year. However, the caveat is that absolute returns will still be mediocre. Ms. X: You showed earlier that corporate bonds had a reasonable year in 2017, albeit falling far short of the returns from equities. A year ago, you recommended only neutral weighting in investment-grade bonds and an underweight in high yield. But you became more optimistic toward both early in 2017, shifting to an overweight position. Are you thinking of scaling back exposure once again, given the tight level of spreads? BCA: Yes, we were cautious on U.S. corporates a year ago because valuation was insufficient to compensate for the deterioration in corporate balance sheet health. Nonetheless, value improved enough early in 2017 to warrant an upgrade to overweight given our constructive macro and default rate outlook. The cyclical sweet spot for carry trades should continue to support spread product for a while longer. Moreover, value is better than it appears at first glance. The dotted line in Chart 27 shows the expected 12-month option-adjusted spread for U.S. junk bonds after adjusting for our base case forecast for net default losses. At 260 basis points, this excess spread is in line with the historical average. In the absence of any further spread narrowing, speculative-grade bonds would return 230 basis points more than Treasurys in 2018. If high-yield spreads were to tighten by another 150 basis points, then valuations would be at a historical extreme, and that seems unwarranted. An optimistic scenario would have another 100 basis point spread tightening, delivering excess returns of 5%. Of course, if spreads widen, then corporates will underperform. If financial conditions tighten in 2018 as we expect then it will be appropriate to lower exposure to corporates. In the meantime, you should favor U.S. and U.K. corporate bonds to issues in the Eurozone because ECB tapering is likely to spark some spread widening in that market. Mr. X: What about EM hard-currency bonds? BCA: The global economic background is indeed positive for EM assets. However, EM debt is expensive relative to DM investment-grade bonds which, historically, has heralded a period of underperformance (Chart 28). We expect that relative growth dynamics will be more supportive of U.S. corporates because EM growth will lag. Any commodity price weakness and/or a stronger U.S. dollar would also weigh on EM bonds and currencies. Chart 27Not Much Value In U.S. Corporates Chart 28Emerging Market Bonds Are Expensive Mr. X: We have not been excited about the bond market outlook for some time and nothing you have said changes my mind. I am inclined to keep our bond exposure to the bare minimum. Ms. X: I agree. So let's talk about the stock market which is much more interesting. As I mentioned before, I am inclined to remain fully invested in equities for a while longer, while my father wants to start cutting exposure. Equity Market Outlook BCA: This is one of those times when it is important to draw a distinction between one's forecast of where markets are likely to go and the appropriate investment strategy. We fully agree that the conditions that have driven this impressive equity bull market are likely to stay in place for much of the next year. Interest rates in the U.S. and some other countries are headed higher, but they will remain at historically low levels for some time. Meanwhile, in the absence of recession, corporate earnings still have upside, albeit not as much as analysts project. However, we have a conservative streak at BCA that makes us reluctant to chase markets into the stratosphere. For long-term investors, our recommended strategy is to gradually lower equity exposure to neutral. However, those who are trying to maximize short-term returns should stay overweight and wait for clearer signs that tighter financial conditions are starting to bite on economic activity. Chart 29Reasons For Caution On U.S. Stocks Getting down to specifics, here are the trends that give us cause for concern and they are all highlighted in Chart 29. Valuation: Relative to both earnings and book value, the U.S. equity market is more expensive than at any time since the late 1990s tech bubble. The price-earnings ratio (PER) for the S&P 500 is around 30% above its 60-year average on the basis of both trailing operating earnings and a 10-year average of earnings. The market is not expensive on a relative yield basis because interest rates are so low, but that will change as rates inevitably move higher. Other developed markets are not as overvalued as the U.S., but neither are they cheap. Earnings expectations: The performance of corporate earnings throughout this cycle - particularly in the U.S. - has been extremely impressive give the weaker-than-normal pace of economic growth. However, current expectations are ridiculously high. According to IBES data, analysts expect long-run earnings growth of around 14% a year in both the U.S. and Europe. Even allowing for analysts' normal optimistic bias, the sharp upward revision to growth expectations over the past year makes no sense and is bound to be disappointed. Investor complacency: We all know that the VIX index is at a historical low, indicating that investors see little need to protect themselves against market turmoil. Our composite sentiment indicator for the U.S. is at a high extreme, further evidence of investor complacency. These are classic contrarian signs of a vulnerable market. Most bear markets are associated with recessions, with the stock market typically leading the economy by 6 to 12 months (Chart 30). The lead in 2007 was an unusually short three months. As discussed earlier, we do not anticipate a U.S. recession before 2019. If a recession were to start in mid-2019, it would imply the U.S. market would be at risk from the middle of 2018, but the rally could persist all year. Of course, the timing of a recession and market is uncertain. So it boils down to potential upside gains over the next year versus the downside risks, plus your confidence in being able to time the top. Chart 30Bear Markets And Recessions Usually Overlap We are not yet ready to recommend that you shift to an underweight position in equities. A prudent course of action would be to move to a broadly neutral position over the next few months, but we realize that Ms. X has a higher risk tolerance than Mr. X so we will leave you to fight over that decision. The timing of when we move to an underweight will depend on our various economic, monetary and market indicators and our assessment of the risks. It could well happen in the second half of the year. Mr. X: My daughter was more right than me regarding our equity strategy during the past year, so maybe I should give her the benefit of the doubt and wait for clearer signs of a market top. Thus far, you have focused on the U.S. market. Last year you preferred developed markets outside the U.S. on the grounds of relative valuations and relative monetary conditions. Is that still your stance? BCA: Yes it is. The economic cycle and thus the monetary cycle is far less advanced in Europe and Japan than in the U.S. This will provide extra support to these markets. At the same time, profit margins are less vulnerable outside the U.S. and, as you noted, valuations are less of a problem. In Chart 31, we show a valuation ranking of developed equity markets, based on the deviation of cyclically-adjusted PERs from their historical averages. The chart is not meant to measure the extent to which Portugal is cheap relative to the U.S., but it indicates that Portugal is trading at a PER far below its historical average while that of the U.S. is above. You can see that the "cheaper" markets tend to be outside the U.S. Japan's reading is flattered by the fact that its historical valuation was extremely high during the bubble years of the 1980s, but it still is a relatively attractive market. Chart 31Valuation Ranking Of Developed Equity Markets From a cyclical standpoint, we are still recommending overweight positions in European and Japanese stocks relative to the U.S., on a currency-hedged basis. Nevertheless, market correlations are such that a sell-off in the U.S. will be transmitted around the world (Chart 32). Chart 32When the U.S. Market Sneezes, The World Catches A Cold Ms. X: I would like to turn the focus to emerging equity markets. You have been cautious on these for several years and that worked out extremely well until 2017. I note from your regular EM reports that you have not changed your stance. Why are you staying bearish given that you see an improvement in global growth and further potential upside in developed equity prices? BCA: The emerging world did extremely well over many years when global trade was expanding rapidly, China was booming, commodity prices were in a powerful bull market and capital inflows were strong. Those trends fostered a rapid expansion in credit-fueled growth across the EM universe and meant that there was little pressure to pursue structural reforms. However, the 2007-09 economic and financial crisis marked a major turning point in the supports to EM outperformance. As we noted earlier, the era of rapid globalization has ended, marking an important regime shift. Meanwhile, China's growth rate has moderated and the secular bull market in commodities ended several years ago. We do not view the past year's rebound in commodities as the start of a major new uptrend. Many emerging equity markets remain highly leveraged to the Chinese economy and to commodity prices (Chart 33). Although we expect the Chinese economy to hold up, growth is becoming less commodity intensive. Finally, the rise in U.S. interest rates is a problem for those countries that have taken on a marked increase in foreign currency debt. This will be made even worse if the dollar appreciates. Obviously, the very term "emerging" implies that this group of countries has a lot of upside potential. However, the key to success is pursuing market-friendly reforms, rooting out corruption and investing in productive assets. Many countries pay only lip service to these issues. India is a case in point where there is growing skepticism about the Modi government's ability to deliver on major reforms. The overall EM index does not appear expensive, with the PER trading broadly in line with its historical average (Chart 34). However, as we have noted in the past, the picture is less compelling when the PER is calculated using equally-weighted sectors. The financials and materials components are trading at historically low multiples, dragging down the overall index PER. Emerging market equities will continue to rise as long as the bull market in developed markets persists, but we expect them to underperform on a relative basis. Chart 33Drivers Of EM Performance Chart 34Emerging Markets Fundamentals Mr. X: One last question on equities from me: do you have any high conviction calls on sectors? BCA: A key theme of our sector view is that cyclical stocks should outperform defensives given the mature stage of the economic cycle. We are seeing the typical late-cycle improvement in capital spending and that will benefit industrials, and we recommend an overweight stance in that sector. Technology also is a beneficiary of higher capex but of course those stocks have already risen a lot, pushing valuations to extreme levels. Thus, that sector warrants only a neutral weighting. Our two other overweights are financials and energy. The former should benefit from rising rates and a steeper yield curve while the latter will benefit from firm oil prices. If, as we fear, a recession takes hold in 2019, then obviously that would warrant a major shift back into defensive stocks. For the moment, the positive growth outlook will dominate sector performance. Ms. X: I agree that the bull market in equities, particularly in the U.S., is very mature and there are worrying signs of complacency. However, the final stages of a market cycle can sometimes be very rewarding and I would hate to miss out on what could be an exciting blow-off phase in 2018. As I mentioned earlier, my inclination is to stay heavily invested in equities for a while longer and I have confidence that BCA will give me enough of a warning when risks become unacceptably high. Of course, I will have to persuade my father and that may not be easy. Mr. X: You can say that again, but we won't bother our BCA friends with that conversation now. It's time to shift the focus to commodities and currencies and I would start by commending you on your oil call. You were far out of consensus a year ago when you said the risks to crude prices were in the upside and you stuck to your guns even as the market weakened in the first half. We made a lot of money following your energy recommendations. What is your latest thinking? Commodities And Currencies BCA: We had a lot of conviction in our analysis that the oil market would tighten during 2017 against a backdrop of rising demand and OPEC production cuts, and that view turned out to be correct. As we entered the year, the big reason to be bearish on oil prices was the bloated level of inventories. We forecast that inventories would drop to their five-year average by late 2017, and although that turned out to be a bit too optimistic, the market tightened by enough to push prices higher (Chart 35). Chart 35Oil Market Trends The forces that have pushed prices up will remain in force over the next year. Specifically, our economic view implies that demand will continue to expand, and we expect OPEC 2.0 - the producer coalition of OPEC and non-OPEC states, led by Saudi Arabia and Russia - to extend its 1.8 million b/d production cuts to at least end-June. On that basis, OECD inventories should fall below their five-year average by the end of 2018. We recently raised our 2018 oil price target to an average of $65 in 2018. Of course, the spot market is already close to that level, but the futures curve is backwardated and that is likely to change. We continue to see upside risks to prices, not least because of potential production shortfalls from Venezuela, Nigeria, Iraq and Libya. Mr. X: The big disruptor in the oil market in recent years was the dramatic expansion in U.S. shale production. Given the rise in prices, could we not see a rapid rebound in shale output that, once again, undermines prices? BCA: Our modeling indicates that U.S. shale output will increase from 5.1 mb/d to 6.0 mb/d over the next year, in response to higher prices. This is significant, but will not be enough to materially change the global oil demand/supply balance. Longer run, the expansion of U.S. shale output will certainly be enough to prevent any sustained price rise, assuming no large-scale production losses elsewhere. A recent report by the International Energy Agency projected that the U.S. is destined to become the global leader in oil and gas production for decades to come, accounting for 80% of the rise in global oil and gas supply between 2010 and 2025. Ms. X: You have suggested that China's economic growth is becoming less commodity intensive. Also, you have shown in the past that real commodity prices tend to fall over time, largely because of technological innovations. What does all this imply for base metals prices over the coming year? BCA: The base metals story will continue to be highly dependent on developments in China. While the government is attempting to engineer a shift toward less commodity-intensive growth, it also wants to reduce excess capacity in commodity-producing sectors such as coal and steel. Base metals are likely to move sideways until we get a clearer reading on the nature and speed of economic reforms. We model base metals as a function of China's PMIs and this supports our broadly neutral stance on these commodities (Chart 36). Chart 36China Drives Metals Prices Mr. X: As usual, I must end our commodity discussion by asking about gold. Last year, you agreed that an uncertain geopolitical environment coupled with continued low interest rates should support bullion prices, and that was the case with a respectable 12% gain since the end of 2016. You also suggested that I should not have more than 5% of my portfolio in gold which is less than I am inclined to own. It still looks like a gold-friendly environment to me. Ms. X: Let me just add that this is one area where my father and I agree. I do not consider myself to be a gold bug, but I think bullion does provide a good hedge against shocks in a very uncertain economic and political world. I would also be inclined to hold more than 5% of our portfolio in gold. BCA: There will be opposing forces on gold during the coming year. On the positive side, it is safe to assume that geopolitical uncertainties will persist and may even intensify, and there also is the potential for an increase in inflation expectations that would support bullion. On the negative side, rising interest rates are not normally good for gold and there likely will be an added headwind from a firmer U.S. dollar. Gold appears to be at an important point from a technical perspective (Chart 37). It currently is perched just above its 200-day average and a key trend line. A decisive drop below these levels would be bearish. At the same time, there is overhead resistance at around 1350-1360 and prices would have to break above that level to indicate a bullish breakout. Traders' sentiment is at a broadly neutral level, consistent with no clear conviction about which way prices will break. There is no science behind our recommendation of keeping gold exposure below 5%. That just seems appropriate for an asset that delivers no income and where the risk/reward balance is fairly balanced. Ms. X: You referred to the likelihood of a firmer dollar as a depressant on the gold price. You also were bullish on the dollar a year ago, but that did not work out too well. How confident are you that your forecast will fare better in 2018? BCA: We did anticipate that the dollar would experience a correction at the beginning of 2017, but we underestimated how profound this move would be. A combination of factors explains this miscalculation. Chart 37Gold At A Key Level It first began with positioning. We should have paid more attention to that fact that investors were massively bullish and long the dollar at the end of 2016, making the market vulnerable to disappointments. And disappointment did come with U.S. inflation weakening and accelerating in the euro area. Additionally, there were positive political surprises in Europe, especially the presidential victory of Emmanuel Macron in France. In the U.S., the government's failure to repeal Obamacare forced investors to lower expectations about fiscal stimulus. As a result, while investors were able to price in an earlier first hike by the ECB, they cut down the number of rate hikes they anticipated out of the Fed over the next 24 months. In terms of the current environment, positioning could not be more different because investors are aggressively shorting the dollar (Chart 38). The hurdle for the dollar to deliver positive surprises is thus much lower than a year ago. Also, we remain confident that tax cuts will be passed in the U.S. by early 2018. As we discussed earlier, U.S. GDP will remain above potential, causing inflation pressures to build. This will give the Fed the leeway to implement its planned rate hikes, and thus beat what is currently priced in the market. This development should support the dollar in 2018. Ms. X: A bullish view on the U.S. dollar necessarily implies a negative view on the euro. However, the European economy seems to have a lot of momentum, and inflation has picked up, while U.S. prices have been decelerating. To me, this suggests that the ECB also could surprise by being more hawkish than anticipated, arguing against any major weakness in the euro. BCA: The European economy has indeed done better than generally expected in the past year. Also, geopolitical risks were overstated by market participants at the beginning of 2017, leaving less reason to hide in the dollar. However, the good news in Europe is now well known and largely discounted in the market. Investors are very long the euro, by both buying EUR/USD and shorting the dollar index (Chart 39). In that sense, the euro today is where the dollar stood at the end of 2016. Chart 38Too Much Pessimism On The Dollar Chart 39Positioning Risk In EUR/USD Valuations show a similar picture. The euro might appear cheap on a long-term basis, but not so much so that its purchasing power parity estimate - which only works at extremes and over long-time periods - screams a buy. Moreover, the euro has moved out of line with historical interest rate parity relationships, warning that the currency is at risk if the economy disappoints. Overall, we expect EUR/USD to trade around 1.10 in 2018. Long-run, the picture is different because a U.S. recession in 2019 would trigger renewed broad-based weakness in the dollar. Mr. X: I have been perplexed by the yen's firmness in the past year, with the currency still above its end-2016 level versus the dollar. I expected a lot more weakness with the central bank capping bond yields at zero and more or less monetizing the government deficit. A year ago you also predicted a weak yen. Will it finally drop in 2018? BCA: We were not completely wrong on the yen as it has weakened over the past year on a trade-weighted basis and currently is about 2% below its end-2016 level. But it has risen slightly against the U.S. dollar. In the past couple of years, the yen/dollar rate has been highly correlated with real bond yield differentials (Chart 40). These did not move against the yen as much as we expected because U.S. yields drifted lower and there was no major change in relative inflation expectations. Chart 40Bond Yield Differentials Drive The Yen The real yield gap is likely to move in the dollar's favor over the next year, putting some downward pressure on the yen. Meanwhile, the Bank of Japan will continue to pursue a hyper-easy monetary stance, in contrast to the Fed's normalization policy. However, it is not all negative: the yen is cheap on a long-term basis, and Japan is an international net creditor to the tune of more than 60% of GDP. Investors are also quite short the yen as it remains a key funding currency for carry trades. Thus, it will continue to benefit each time global markets are gripped with bouts of volatility. It remains a good portfolio hedge. Ms. X: Are any other currency views worth noting? BCA: The outlook for sterling obviously will be tied to the Brexit negotiations. Having fallen sharply after the Brexit vote, sterling looks cheap relative to its history. This has allowed it to hold in a broad trading range over the past 18 months, even though the negotiations with the EU have not been going well. At this stage, it is hard to know what kind of deal, if any, will emerge regarding Brexit so we would hedge exposure to sterling. Our optimism toward the oil price is consistent with a firm Canadian dollar, but developments in the NAFTA negotiations represent a significant risk. At the moment, we are overweight the Canadian dollar, but that could change if the NAFTA talks end badly. We still can't get enthusiastic about emerging market currencies even though some now offer reasonable value after falling sharply over the past few years. Mr. X: We can't leave currencies without talking about Bitcoin and cryptocurrencies in general. I like the idea of a currency that cannot be printed at will by governments. There are too many examples of currency debasement under a fiat money system and the actions of central banks in recent years have only served to increase my mistrust of the current monetary system. But I can't profess to fully understand how these cryptocurrencies work and that makes me nervous about investing in them. What are your thoughts? BCA: You are right to be nervous. There have been numerous cases of hackers stealing Bitcoins and other cryptocurrencies. Also, while there is a limit to the number of Bitcoins that can be issued, there is no constraint on the number of possible cryptocurrencies that can be created. Thus, currency debasement is still possible if developers continue creating currencies that are only cosmetically different from the ones already in existence. Moreover, we doubt that governments will sit idly by and allow these upstart digital currencies to become increasingly prevalent. The U.S. Treasury derives $70 billion a year in seigniorage revenue from its ability to issue currency which it can then redeem for goods and services. At some point, governments could simply criminalize the use of cryptocurrencies. This does not mean that Bitcoin prices cannot rise further, but the price trend is following the path of other manias making it a highly speculative play (Chart 41). If you want more detail about our thoughts on this complex topic then you can read the report we published last September.2 Chart 41Bitcoin Looks Like Other Bubbles Ms. X: I don't fear bubbles and manias as much as my father and have made a lot of money during such episodes in the past. But I am inclined to agree that Bitcoin is best avoided. The topic of manic events presents a nice segue into the geopolitical environment which seems as volatile as ever. Geopolitics Ms. X: Which geopolitical events do you think will have the biggest impact on the markets over the coming year? BCA: Domestic politics in the U.S. and China will be very much in focus in 2018. In the U.S., as we discussed, the Republicans will pass tax cuts but it is unclear whether this will help the GOP in the November midterm elections. At this point, all of our data and modeling suggests that Democrats have a good chance of picking up the House of Representatives, setting a stage for epic battles with President Trump about everything under the sun. In China, we are watching carefully for any sign that Beijing is willing to stomach economic pain in the pursuit of economic reforms. The two reforms that would matter the most are increased financial regulation and more aggressive purging of excess capacity in the industrial sector. The 19th Party Congress marked a serious reduction in political constraints impeding President Xi's domestic agenda. This means he could launch ambitious reforms, akin to what President Jiang Zemin did in the late 1990s. While this is a low-conviction view, and requires constant monitoring of the news and data flow out of China, it would be a considerable risk to global growth. Reforms would be good for China's long-term outlook, but could put a significant damper on short-term growth. The jury is out, but the next several months will be crucial. Three other issues that could become market-relevant are the ongoing North Korean nuclear crisis, trade protectionism, and tensions between the Trump administration and Iran. The first two are connected because a calming of tensions with North Korea would give the U.S. greater maneuvering room against China. The ongoing economic détente between the U.S. and China is merely a function of President Trump needing President Xi's cooperation on pressuring North Korea. But if President Trump no longer needs China's help with Kim Jong-Un, he may be encouraged to go after China on trade. As for Iran, it is not yet clear if the administration is serious about ratcheting up tensions or whether it is playing domestic politics. We suspect it is the latter implying that the market impact of any brinkmanship will be minor. But our conviction view is low. Mr. X: We seem to be getting mixed messages regarding populist pressures in Europe. The far right did not do as well as expected in the Netherlands or France, but did well in Austria. Also, Merkel is under some pressure in Germany. BCA: We don't see much in the way of mixed messages, at least when it comes to support for European integration. In Austria, the populists learned a valuable lesson from the defeats of their peers in the Netherlands and France: stay clear of the euro. Thus the Freedom Party committed itself to calling a referendum on Austria's EU membership if Turkey was invited to join the bloc. As the probability of that is literally zero, the right-wing in Austria signaled to the wider public that it was not anti-establishment on the issue of European integration. In Germany, the Alternative for Germany only gained 12.6%, but it too focused on an anti-immigration platform. The bottom line for investors is that the European anti-establishment right is falling over itself to de-emphasize its Euroskepticism and focus instead on anti-immigration policies. For investors, the former is far more relevant than the latter, meaning that the market relevance of European politics has declined. One potential risk in 2018 is the Italian election, likely to be held by the end of the first quarter. However, as with Austria, the anti-establishment parties have all moved away from overt Euroskepticism. At some point over the next five years, Italy will be a source of market risk, but in this electoral cycle and not with economic growth improving. Ms. X: The tensions between the U.S. and North Korea, fueled by two unpredictable leaders, have me very concerned. I worry that name-calling may slide into something more serious. How serious is the threat? BCA: The U.S.-Iran nuclear negotiations are a good analog for the North Korean crisis. The U.S. had to establish a "credible threat" of war in order to move Iran towards negotiations. As such, the Obama administration ramped up the war rhetoric - using Israel as a proxy - in 2011-2012. The negotiations with Iran did not end until mid-2015, almost four years later. We likely have seen the peak in "credible threat" display this summer between the U.S. and North Korea. The next two-to-three months could revisit those highs as North Korea responds to President Trump's visit to the region, as well as to the deployment of the three U.S. aircraft carriers off the coast of the Korean Peninsula. However, we believe that we have entered the period of "negotiations." It is too early to tell how the North Korean crisis will end. We do not see a full out war between either of the main actors. We also do not see North Korea ever giving up its nuclear arsenal, although limiting its ballistic technology and toning down its "fire and brimstone' rhetoric is a must. The bottom line is that this issue will remain a source of concern and uncertainty for a while longer. Conclusions Mr. X: This seems a good place to end our discussion. We have covered a lot of ground and your views have reinforced my belief that it would make good sense to start lowering the risk in our portfolio. I know that such a policy could leave money on the table as there is a reasonable chance that equity prices may rise further. But that is a risk I am prepared to take. Ms. X: I foresee some interesting discussions with my father when we get back to our office. At the risk of sounding reckless, I remain inclined to stay overweight equities for a while longer. I am sympathetic to the view that the era of hyper-easy money is ending and at some point that may cause a problem for risk assets. However, timing is important because, in my experience, the final stages of a bull market can deliver strong gains. BCA: Good luck with those discussions! We have similar debates within BCA between those who want to maximize short-run returns and those who take a longer-term view. Historically, BCA has had a conservative bias toward investment strategy and the bulk of evidence suggests that this is one of these times when long-run investors should focus on preservation of capital rather than stretching for gains. Our thinking also is influenced by our view that long-run returns will be very poor from current market levels. Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation (Table 3). That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. There is a negligible equity risk premium on offer, implying that stock prices have to fall at some point to establish higher prospective returns. Table 310-Year Asset Return Projections The return calculations for equities assume profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or PERs stay at historically high levels. In that case, equities obviously would do better than our estimates. In terms of the outlook for the coming year, a lot will depend on the pace of economic growth. We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. That is possible, but we would not make it our base case scenario. Ms. X: You have left us with much to think about and I am so glad to have finally attended one of these meetings. My father has always looked forward to these discussions every year and I am very happy to be joining him. Many thanks for taking the time to talk to us. Before we go, it would be helpful to have a recap of your key views. BCA: That will be our pleasure. The key points are as follows: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflation pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets. The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the odds of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the euro area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China's economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their "dots" projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal currently have 10-year government bond real yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The euro area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 20, 2017 1 This comprises consumer spending on durables, housing and business investment in equipment and software. 2 Please see 'Bitcoin's Macro Impact', BCA Global Investment Strategy Special Report, September 15, 2017.
Highlights The cyclical bull market in stocks will last until the end of next year. That said, global equities have become increasingly vulnerable to a correction, so fast-money investors should consider putting on a tactical hedge spanning the next few weeks. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. We ultimately expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a larger budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Feature Rising Odds Of A Stock Market Correction We remain cyclically bullish on global equities based on the expectation that global growth will stay strong over the next 12 months, which should support corporate earnings. Nevertheless, the recent price action in credit markets is disconcerting. Yesterday's relief rally notwithstanding, junk bonds have been selling off in recent weeks, as have EM credit and currencies (Chart 1). We have found that credit trends generally lead the stock market. This raises the risk of an equity correction. The fact that the bull/bear ratio has reached a 30-year high in the weekly Investors Intelligence Sentiment survey (Chart 2), and that the most recent BofA Merrill Lynch Survey shows that a record share of fund managers are overweight risk assets, only add to our worries. Chart 1Junk Bond Selloff Raises ##br##Risks Of An Equity Correction Chart 2Equity Bullish Sentiment:##br## Getting Stretched Doubts about the ability of Republicans in Congress to push through tax cuts further muddle the picture. We continue to expect a tax bill to be signed into law early next year, but the intention of President Trump and Senator Majority Leader Mitch McConnell to include a provision in the bill to rescind the individual mandate to purchase health insurance could greatly complicate this task. Moreover, as we discuss in greater detail below, the economic benefits of the tax legislation are likely to be muted, even if equity prices do rise on the back of lower corporate tax rates. This will make selling the merits of the tax plan to the American people all the more difficult. With all this in mind, we are putting on a short S&P 500 trade recommendation. We are targeting a gain of 5% and putting in a stop-loss of 2%. We will close this trade before the end of the year, so this should be seen as a purely tactical decision appropriate for fast-money investors only. Fiscal Policy Was Tightened Too Early ... Global bond yields plummeted during the Great Recession, but then quickly recovered. The U.S. 10-year Treasury yield hit 3.95% in June 2009, while the German bund yield reached 3.72% that same month. Today, output gaps are much smaller globally than they were seven years ago, yet bond yields are substantially lower (Chart 3). Chart 3ASmaller Output Gaps... Chart 3B...But Lower Bond Yields Many theories have been offered to account for this seemingly paradoxical turn of events. Was it QE? Maybe the Phillips curve broke down? Perhaps investors have steadily revised down their estimate of the neutral rate of interest? One can make compelling arguments in support of all these explanations. However, there is one reason that has received relatively little attention: fiscal policy. Chart 4 shows that fiscal policy was tightened by an average of 4.1% of GDP in the G20 economies between 2010 and 2015. This happened despite the fact that unemployment was still quite high. One could make a half-plausible case that fiscal austerity was necessary in southern Europe, where one country after another was being attacked by the bond vigilantes (although even there, the failure of the ECB to act as a lender of last resort to European sovereigns greatly exacerbated the problem). It is harder to justify the shift towards austerity in countries such as the U.S. and the U.K. which were able to issue debt in their own currencies; or to explain why Germany felt the need to tighten fiscal policy when its structural primary balance was already in surplus. In Japan's case, the 2.9% of GDP in fiscal tightening that occurred between 2013 and the 2015 was a key reason why Abenomics failed to push the country out of deflation. Faced with the reality of what was happening on the fiscal front, central banks had no choice but to step in. They did so by slashing interest rates, in some cases pushing them into negative territory. They also engaged in massive asset purchases. The tsunami of easy money helped to keep economies afloat. But in many countries, slower government debt growth was replaced by faster private-sector debt growth (Chart 5). Debt continued to rise. It just did so in a different form. Chart 4Fiscal Belt-Tightening##br## In 2010-2015 Chart 5Private Debt Growth Picked Up##br## Amid Slowing Government Debt Growth ... And Is Now Being Eased Too Late The good news is that governments are abandoning their obsession with fiscal austerity. The bad news is that they are doing it at a time when fiscal easing is no longer warranted. Standard economic theory suggests that governments should run budget deficits when unemployment is high, and surpluses when it is low. In the U.S., the unemployment rate stands at 4.1%, 0.6 percentage points below the Fed's estimate of NAIRU. And yet, President Trump and the Republicans in Congress are pushing for massive tax cuts which, according to the CBO, would add $1.7 trillion to federal debt over the next ten years, while pushing up the debt-to-GDP ratio by an extra six percentage points to 97% (Chart 6). Limited Supply-Side Benefits Proponents of the legislation argue that lower tax rates will spur growth by so much that they will pay for themselves. This is highly unlikely. Chart 7 shows that major tax cuts in the past have always led to a rising debt-to-GDP ratio, whereas tax hikes have led to a deceleration, or even outright decline, in the debt ratio. Even the much lauded 1981 Reagan tax cuts had to be partially rolled back in 1982 after the budget deficit widened sharply. Chart 6More Red Ink Chart 7Do Tax Cuts Pay For Themselves? The growth-enhancing effects of lower tax rates are likely to be smaller at present than they were in the early 1980s. The Reagan tax cuts were introduced when the economy was in the doldrums and government debt levels were much lower than they are today. Cross-border ownership of foreign assets has also increased tremendously since the Reagan era. Foreigners now own more than $10 trillion of U.S. equities, or close to 35% of the total, up from 10% in the early 1980s (Chart 8). This implies that a corporate tax cut would not only represent a massive windfall for foreigners - a bizarre outcome for a self-professed nationalist president - but would mean that a smaller share of capital gains taxes will make their way into the coffers of the U.S. Treasury. Personal income tax cuts are also likely to generate much less bang for the buck. Most empirical studies suggest that lower personal tax rates increase labor supply largely by boosting female labor participation.1 The prime-age female labor participation rate in the U.S. today is 11 points higher than it was in 1980, which limits the scope for further gains. Moreover, when Ronald Reagan cut taxes in 1981, the top personal tax rate stood at 70% (Chart 9). At such a high rate, a one percentage-point cut in the top rate increases take-home pay by 3.3% (1/30). Today, the top rate stands at 39.6%, so a one-point cut would raise after-tax income by only 1.6% (1/60.4). Thus, the incentive effect from cutting the top marginal tax rate is only half of what it was back then. And, of course, the lower the tax rate, the less incremental revenue the government gets from every additional dollar of income. A reasonable estimate is that the revenue offset from tax cuts today would be only one-quarter of whatever modest amount it was in the early 1980s. Chart 8Growing Share Of U.S. Equities##br## Is Held By Foreigners Chart 9Lower Bang For The Buck From##br## Cutting Individual Tax Rates Tax Cuts Versus Tax Reform This is not to say that tax reform is undesirable. Statutory corporate tax rates in the U.S. are quite high, but effective rates are very low, given the myriad deductions and tax-sheltering strategies (Chart 10). The combination of base-broadening and lower statutory rates would make the economy more efficient. In this respect, the set of reforms unveiled by Paul Ryan earlier this year actually had a lot going for it. Unfortunately, the half-measures in both the House and Senate bills run the risk of making the current system even worse. For example, the proposed transition from the current system where U.S. companies are taxed on their worldwide profits to one where they are taxed only on the profits they earn in the U.S. is likely to increase the incentive to use accounting gimmicks to shift more taxable income to low-tax jurisdictions abroad.2 The new "pass through" tax rate of 25% would also provide passive business owners, who are currently subject to the top marginal tax rate, with a massive tax break. Chart 10Statutory Vs. Effective Corporate Tax Rates: Please Mind The Gap In theory, full business investment expensing is a good idea, but the economic impact is likely to be modest. Companies pay less tax upfront when they can write off the value of capital expenditures immediately, but incur higher taxes in the future due to the absence of any further depreciation expenses. When interest rates are low, as they are today, the present value gain from shifting tax liabilities around in this way is bound to be small. This, along with the fact that companies can already write off a large share of capital purchases under current law in the first few years after they are made, will limit the benefits of the proposal. The full expensing of capital purchases also expires after five years under the Republican plan. This could cause companies to pull forward capital spending simply to game the tax code. Such a policy could be justified if the economy were depressed, but that is not the case today. The Tax Foundation, a free-market think tank that a number of left-leaning economists have accused of overstating the benefits of tax cuts, estimates that temporary expensing would raise the level of real GDP by only 0.18% after a decade, compared to 1.6% in the case of permanent expensing.3 From Populism To Pluto-Populism Chart 11This Is Not Populism Martin Wolf has aptly referred to Donald Trump as a "pluto-populist" - someone who talks like a champion of the poor and middle class to his adoring supporters, but actually pushes for policies that mainly benefit the wealthiest Americans.4 Many of the proposals in the Republican tax bills - including the abolition of the Alternative Minimum Tax, the phase-out of the estate tax, and the aforementioned reduction in the business pass-through tax - would further skew the distribution of income towards the rich (Chart 11). Indeed, the benefits for the wealthy grow over time under the proposed plans, even as those for the middle class dissipate, eventually reaching the point where the average middle-class household ends up paying more taxes under the House plan than they do now (Chart 12).5 And no, one cannot say that this outcome is simply the inevitable consequence of the fact that the rich pay most of the taxes. Once regressive taxes such as the payroll tax and state and local taxes are included in the tally, the rich pay about the same share of their income in taxes as the middle class (Chart 13). To make matters worse, the Republican tax bill would trigger $25 billion in Medicare cuts and $111 billion in cuts to other government programs under current PAYGO rules. More pain for middle-class voters. Donald Trump was quick to throw Ed Gillespie under the bus after he failed to win the governor's race in Virginia, tweeting that Gillespie "did not embrace me or what I stand for." But the truth is Trump has not embraced Trumpism either. We were widely scorned in the early days of the primary season for saying that Trump would secure the Republican nomination, and mocked again in 2016 for predicting that he would win the presidential election. At this point, however, the odds are high that the Republicans will lose the House next November and Trump will fail to get re-elected in 2020. Chart 12Middle-Class Tax Cuts Will Morph Into Tax Hikes Chart 13U.S. Taxation Not Very Progressive Investment Conclusions U.S. equities are overbought and ripe for a correction. As is almost always the case, lower stock prices in the U.S. will negatively impact global bourses. Fortunately, the selloff is likely to be short-lived, with strong global growth and rising earnings powering stocks into 2018. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. Nevertheless, we expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a wider budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Chart 14Inflation Higher In Countries Lacking Independent Central Banks Higher government debt levels will also increase the temptation to inflate away debt. As we discussed a few weeks ago, rising political polarization is affecting every facet of society, with the NFL just being the latest example.6 It is hard to believe that the Fed will remain above the fray. History suggests that the loss of central bank independence is often associated with higher inflation (Chart 14). Such may be America's fate as well. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Robert K. Triest, "The Effect Of Income Taxation On Labor Supply In The United States," The Journal of Human Resources, Special Issue on Taxation and Labor Supply in Industrial Countries, 25:3 (Summer 1990); and Costas Meghir and David Phillips, "Labour Supply And Taxes," IZA Discussion Paper No. 3405 (March 2008). 2 Both the House and Senate versions of the tax bill have a number of provisions to limit the ability of corporations to shift profits abroad, but at present, it is unclear how effective these measures will be. 3 Please see "Economic and Budgetary Impact of Temporary Expensing," Tax Foundation, dated October 4, 2017. 4 Martin Wolf, "Donald Trump Embodies How Great Republics Meet Their End," Financial Times, March 1, 2016. 5 This mainly occurs because the "Family Flexibility Credit" expires after 2022. The expanded Child Tax Credit is also not indexed to inflation under the House plan, implying that its value to tax filers will go down over time. In addition, the repeal of the individual mandate would cause fewer lower-income earners to buy health insurance, leading them to forego the tax subsidies that they would otherwise receive. 6 Please see , "Three Demographic Megatrends," dated October 27, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018. Synchronous global growth remains in place in 2017 and will persist into 2018, providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Is another "Great Moderation" at hand? Feature Uncertainty around the GOP tax plan led to a weaker dollar last week, but U.S. equities and Treasuries were little changed. The tax plan could fail if enough Republican voters turn against it. BCA's Geopolitical Strategy team notes1 that as long as President Trump remains more popular with Republican voters than his Republican peers in Congress, he will be able to force the tax plan through both the Senate and the House. Moreover, we could even see some Democrats in the Senate supporting these tax changes. Ahead of the OPEC meeting on November 30, the weaker dollar along with the ongoing political turmoil boosted oil prices. Closer to home, corporate profits for Q3 2017 and guidance for Q4 2017 and beyond remains supportive for risk assets, although BCA expects S&P 500 earnings growth to peak in the next couple of quarters on a 4-quarter moving average basis. Global growth remains supportive for S&P 500, U.S. economic growth, and ultimately, higher inflation. Meanwhile, investors are still asking when price and wage inflation will turn higher toward the Fed's 2% forecast. BCA's answer: Be patient. In the final section of this week's report, we examine whether the recent period of low economic and financial market volatility will persist and herald a return to the Great Moderation. Q3 Earnings Season: Margins Still Expanding EPS and sales growth in Q3 ran well ahead of consensus expectations as forecasted in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Over 90% of companies have reported results so far, with 72% beating consensus EPS projections, just above the long-term average of 69%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the long-term average of 55%. The surprise factor for year-over-year results in Q3 stands at 5% for EPS and 1% for sales. These compare favorably with the average EPS (4%) and sales (1%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Margins tend to peak halfway through late-cycle periods.2 Nonetheless, the results imply that Q3 will be another quarter of margin expansion. Earnings growth (Q3 2017 versus Q3 2016) is solid at 8%, and in revenues, 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in 8 of the 11 sectors. The 7.3% year-over-year drop in the financial sector is attributed to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up by 6% from a year ago. EPS results are particularly impressive in energy (162%), and strong in technology (24%), healthcare (8%), and materials (7%). These sectors likewise experienced significant sales gains (17%, 10%, 4%, and 9%, respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 1). Trump's name was mentioned only twice in the Q3 earnings calls held through November 10, doubling the total in Q2. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The zenith in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 1Managements Focused On The Message##BR##Not The Man In DC In contrast, "tax" and "reform" have appeared 13 times so far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2 when investors were skeptical that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.3 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 2). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 projection. The divergence can be explained by the effect of the hurricanes on the financial sector's earnings in 2017 and the probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). Margins will crest in 2018. Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any encouraging effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, but would bring forward Fed rate hikes. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Chart 2Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Chart 3Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Global Growth Update Synchronous global growth remains in place in 2017 and will persist into 2018,5 providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. Global real GDP estimates continue to move higher, a welcome departure from the past when estimates slid relentlessly lower (Chart 4). Since the start of 2017, GDP estimates for this year have increased from 2.6% to 3.2%, while 2018 forecasts have accelerated from 2.8% to 3%. The 2019 growth projection is steady at 2.9%. This upward trajectory for 2017 and 2018 has occurred despite a recalibration by many major central banks away from accommodative policies. The improving growth forecasts could be short-circuited by aggressive central bank actions, a worldwide trade war, or escalating tensions in Northeast Asia (or a combination of all three). Falling oil prices would also challenge a quickening of world growth, but BCA's stance is that oil prices will move up significantly in the coming year.6 Chart 4Global Growth Estimates Accelerating Global leading indicators are on the upswing. The most recent update of our Global Leading Indicator (excluding the U.S.) was the strongest since 2010 when it slowed after a sharp rebound from the 2007-2009 financial crisis. Moreover, the global LEI diffusion index turned positive after a worrisome dip below 50% earlier this year. It will be a warning sign for wide-reaching growth if the diffusion index moves back below 50% (Chart 5). Industrial production (IP) overseas is expanding at nearly three times the U.S. rate (Chart 6). This suggests that U.S. economic activity will be pulled up by foreign demand. Additionally, G3 capital goods orders are climbing at the fastest pace since 2014. A stronger dollar may dampen U.S. exports and earnings, but this will be a modest offset, rather than something that derails the recovery in U.S. industrial production. Chart 5Global LEI's Pointing Higher Chart 6Supports For Global Growth In Place Global growth is important to large cap U.S. equities because 43% of S&P 500 sales in 2016 came from outside the U.S. (Table 2). Remarkably, this figure moved lower in the past 5 years and 10 years. In 2012, 47% of S&P 500 sales came from outside the U.S.; in 2007, it was only 1% less. The drop in overseas sales since 2012 masks shifts by region. In 2016, 8% of S&P 500 sales were to Asia, up 100 bps from 2012. Europe, excluding the U.K., accounted for 6% sales in 2016 and the U.K., a mere 1%. These numbers dropped from the 2012 figures of 10% and 2% respectively. While Standard and Poor's does not separate out sales to China, that country represents a large portion of sales to Asia, which makes China and Europe the two most important regions for overseas sales. In contrast, only 3% of S&P 500 sales are made in Canada and Mexico. Table 2Most S&P 500 Sales Go To Asia And Europe While BCA's European strategists remain upbeat about growth prospects in the Eurozone,7 our outlook on China is more sanguine. BCA's Geopolitical Strategy service notes that Chinese politics have shifted from tailwind to headwind for global growth in the wake of China's 19th National Party Congress.8 Meanwhile, BCA's China Investment Strategy states that the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that probably will not recur in the coming 6-12 months. While Chinese export growth will moderate in the coming year, the absence of these shocks is an important factor supporting a gradual deceleration.9 Moreover, China's economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic, all are expanding at double-digit rates, albeit down from recent peaks (Chart 7). Various price indexes also show a broadly based pickup in inflation to levels that will unnerve the authorities. Nonetheless, economic growth will slow in 2018 as policymakers continue to pare back stimulus. BCA does not foresee a substantial downturn in growth next year, but it could be hard on base metals prices. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both domestic economic growth and profits of U.S. firms with significant foreign business. Moreover, surging world growth is a precondition for higher inflation. BCA's Global Fixed Income Strategy service notes10 that 68% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", which has not occurred since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 8). Solid foreign demand will help the economy hit the Fed's GDP target and support the central bank's additional but gradual tightening stance. Stay overweight U.S. equities and remain short duration. BCA's view that inflation is poised to turn higher also supports our duration call. Chart 7China: Healthy Growth Indicators Chart 8NAIRU Is Not Dead Yet Still Waiting For Wage Inflation Table 3Inflation Reacts With A Lag The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Given that inflation is a lagging indicator, investors must remain patient. Table 311 illustrates the time lag from when full employment is reached to the turning point for consumer price inflation. During long expansions, the gap is 26 months. The U.S. unemployment rate dipped below NAIRU 12 months ago in November 2016. The implication is that investors (and the Fed) are too eager as they wait for inflation's inflection point. BCA approaches wage growth - or the lack of it - in another way. Like inflation, wage growth takes time to materialize in protracted recoveries. Charts 9 and 10 provide updates on inflation and its leading indicators that we published in August 2017. These charts reiterate that price pressures take time to emerge in "slow burn" expansions. Chart 11 shows that the ECI has trended higher since 2009, matching increases in quit rates, NFIB compensation plans, and the Conference Board's measure of jobs hard to get less jobs easy to get. Moreover, the top panel of Chart 11 shows that the ECI gains are widespread and at 73%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 12). Chart 9In the 80s And 90s Wage Growth Did Not##BR##Provide And Early Warning On Inflation Chart 10Patience Is Required On##BR##Inflation In Long Cycles Chart 11Labor Market Is Tight Enough##BR##To Push Up Inflation Chart 1270%+ Of States Have Unemployment Rates Below NAIRU The Atlanta Fed Wage Tracker,12 which is not compromised by compositional shifts in the labor market, stabilized in the past few months after rolling over in the spring and early summer. Moreover, the Tracker remains in a distinct uptrend; at 3.6% year-over-year, it is at the lower end of the 3.3% to 4.3% year-over-year range in place before the global financial crisis (Chart 13, panel 2). Chart 13Wage Pressures Mounting Bottom Line: Wage inflation is on the upswing as the output gap turns positive for the first time in a decade and the unemployment rate moves even further below NAIRU. A persistent buildup in wages will allow the Fed to bump up rates in December and three times again next year. This supports BCA's underweight stance on duration. That said, a sudden surge in consumer price or wage inflation would trigger a more aggressive response from the Fed, and a signal of "the beginning of the end" for the recent return of the Great Moderation. Great Moderation, Interrupted? The Great Recession was eight years ago, but investors are now ruminating about the return of the Great Moderation era (mid-1980s to mid-2007), when subdued macroeconomic volatility often coincided with low market volatility. Then, as now, inflation was muted and stable, but unlike today, economic growth was much faster in a long expansion phase with two mild recessions (Chart 14). There have been many studies rationalizing the Great Moderation, which was observed in most advanced economies (G7 countries and Australia) roughly at the same time though not fully synchronized (Chart 15).The phenomenon13 was initially forged in 2002 by Stock and Watson and then publicized by former Fed Chair Bernanke14 in a 2004 speech.15 Chart 14Return Of The Great Moderation? Chart 15The Great Moderation: A Global Phenomenon Too! Three main causes were identified: Structural changes in the economy: improvement in inventory management as the U.S. moved away from a manufacturing-based economy towards a service-based economy, the latter less volatile. Financial innovations, for example, increased credit availability to households through the rise of securitization, allowing consumption to be more balanced; Higher efficacy of monetary policy: increased transparency and predictability of FOMC actions, which augmented the Fed's credibility to tame inflation (price stability) and foster full employment; Good Luck (smaller shocks): post mid-1980s (and up to the global financial crisis-GFC), the economy did not experience outsized shocks such as the surge in oil prices in the 1960s and the 1970s. Most investors and/or economists agree that structural changes and better monetary policy were significant drivers of the decline in macroeconomic volatility. Good luck also seems to have been a factor and there is empirical research to support it. The persistence and length of the current expansion is an indication that good luck still plays a role, with investors taking on risk and becoming complacent. That said, there does not seem to be a consensus on the single most important driver of the "Great Moderation". Interestingly, complacency in the financial markets creates vulnerability at the late stage in this expansion. It has caught the Fed's attention as evidenced in the September 19-20 FOMC minutes: "Broad U.S. equity price indexes increased over the intermeeting period. One-month-ahead option-implied volatility of the S&P 500 index - the VIX - remained at historically low levels despite brief spikes associated with increased investor concerns about geopolitical tensions and political uncertainties." Since Chair Yellen took office in February 2014, this is the most direct reference about low volatility and therefore, complacency in the financial markets. Chart 16Back To Low Correlations Among Stocks The November 2017 Bank Credit Analyst Monthly Report16 discussed complacency in the context of a return of the Great Moderation. BCA believes significant complacency is signaled by the good news already discounted in equity prices, the depressed level of the VIX and the decline this year in risk asset correlations. Moreover, large institutional investors are reportedly selling volatility and thus, dampening implied volatility across asset classes. The "Great Moderation" in macro volatility is also contributing to low correlations among stocks (Chart 16). The idea is that low perceived macroeconomic volatility during the "Great Moderation" had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. The focus on alpha contributed to the decline in stock price correlation. Today, dispersion in the outlooks for growth and interest rates have returned to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart 17). Some of the reduced dispersion can be justified by the fundamentals. The onset of a broadly based global expansion has calmed lingering fears that the world economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has also moderated (bottom panel). Historically, implied volatility tended to fall when global industrial production was strong and global earnings were rising in a broad swath of countries (Chart 18). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to drop. The lower correlations occur as earnings fundamentals become more important performance drivers, and sector differentiation generates alpha.17 Similarly, the VIX can fluctuate at low levels for an extended time when global growth is broadly based. Chart 17A Less Uncertain Macro Outlook? Chart 18Broad-Based Growth Lowers Implied Volatility Still, the current readings of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table 4 shows the drop in the S&P 500 index during non-recessionary periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during those nine episodes, with a range of -3.6 to -18.1%. Table 4Episodes When VIX Spiked Bottom Line: Longer expansions and shorter recessions, alongside the decline in market volatility, may stay for a while, the result of the perceived return to the Great Moderation. Risk assets are thus vulnerable because a lot of good news is discounted. Nonetheless, we would view any pullback in equities as a healthy correction rather than the beginning of a bear market. If the next recession is not expected before 2019 (our base case), then it is too early for the equity market to begin to discount the next bear market because profits will continue to expand well into 2018. Stay overweight stocks versus bonds in the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much for Populism," November 8, 2017. Available at gps.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Synchronicity," September 25, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 7 Please see BCA Research's European Investment Strategy Weekly Report, "The Great Resynchronization," September 21, 2017. Available at eis.bcaresearch.com 2017. 8 Please see BCA Research's Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?," November 1, 2017. Available at gps.bcaresearch.com. 9 Please see BCA Research's China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part I): Trade," October 26, 2017. Available at cis.bcaresearch.com. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," September 12, 2017. Available at gfis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 12 https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 13 Peter M. Summers, "What Caused the Great Moderation" Some Cross-Country Evidence", 2005, Federal Reserve Bank of Kansas City www.kansascityfed.org/ROkYZ/OcgaZ/Publicat/econrev/PDF/3q05summ.pdf 14 James H. Stock and Mark W. Watson, "Has the Business Cycle Changed? Evidence and Explanations", August 2003 https://www.kansascityfed.org/publicat/sympos/2003/pdf/Stockwatson2003.pdf 15 Governor Ben S. Bernanke, "The Great Moderation," Washington, DC, February 20, 2004, https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/ 16 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 17 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," published October 23, 2017. Available at uses.bcaresearch.com.